Tuesday, May 13, 2014

LUV: Upside potential

Update 2/9/2015; I've exited my position in LUV and calcualated results.

The share price rose by +44.7% over the 92-day lifespan of the position, or a +92% annual rate.

There were no hedges.

Update 8/15/2014: I've moved LUV from the Roll Shelf into a fresh position after it broke above its 20-day price channel, and confirmed the re-entry signal the next day by trading above that level.

In the process of doing so, I've changed the series from options-only under my shorter-term rules to long shares with the potential for bearish hedges during downturns under my longer-term rules, which may be read here

This means that I'll hold LUV at a minimum past Aug. 15, 2015 in order to take advantage of long-term capital gains tax rates.

I've had LUV on my Innovators list since its inception a few months ago. The list is of symbols that I find interesting because of their innovative style of management. LUV has been cited in several places for its customer-centered policies and devolution of authority to employees to immediately redress customer unhappiness. The immediate prompt to include company is a mention in a book on innovation I've just completed, MEMEnomics: The Next Generation Economic System, by Said Dawlabani.

The chart below continues, in greater details, the right-hand chart that accompanies the original analysis, deconstructing via Elliott wave analysis the rise from April 14. My best count puts LUV in a series of 3rd waves to the upside, typically the most energetic waves of a trend, which is quite a bullish position.

Click on chart to enlarge.
LUV 90 days 2-hour bars

Update 7/24/2014: LUV rose 6.4% in three days, including an immediate response to an earnings announcement. I closed my bull position and moved the symbol to the roll shelf. 

The options that I used to build the position expire Aug. 15, and this seemed to be a good opportunity to roll forward, even though it is a couple of weeks earlier than usual. The chart remains quite bullish.

I'll re-open a bull position in LUV when the price closes above today's 20-day price channel boundary of $28.97 and confirms it by trading above that level the next day.

A decline below the 10-day channel boundary, presently at $26.93, would end the roll series, and at that point I would calculate profit and loss.

Update 7/16/2014: LUV broke above its 20-day price channel on July 15 and confirmed the bull signal by trading still higher the next trading day. 

I've pulled it from the Roll Shelf and opened a new bull position, structured as a vertical spread sold for a credit, short the $28 puts and long the $26 puts, and expiring Aug. 15.

The options position is the equivalent of 106 shares and has leverage a bit higher than 3:1.

Update 6/13/2014: LUV dropped below its stop/loss level and I exited the position, moving the symbol to the Roll Shelf. My practice is to refrain from calculating profit and loss until a symbol's series is completed, that is, until it is both no longer a position and no longer on the Roll Shelf.

I see wave 2 {-4} as having topped at $27.70 on June 9, suggesting that there is more upside to come before the rise from $12.58 beginning July 3, 2013, is complete, ending wave 3 of the base degree, which began April 23, 2012 from $7.76.

Update 5/13/2014: I've opened a bull position in LUV, structuring it as a bull call spread, bought with a debit and expiring in September, long the $23 call and short the $25 call. The leverage is 4.6:1.

Southwest Airlines Co. (LUV), like much of the market, has been on the rise since October 2011.

It added another wrinkle to the uptrend with a small correction in April and then resumed the climb, and by Monday had broken above its highest price of the past 20 days. The bull signal was confirmed in today's trading as LUV traded still higher.

Over the shorter term, I see upside potential on the LUV chart, although some major uptrending components of the analysis are in their final stages.

The Chart

LUV is in the midst of what Elliott wave analysts call an extended wave. Several of them actually, an extended third wave in the base degree and an extended fifth wave in the {-2} degree.

Wave extension is not a concept that I find useful in my own work with Elliott. I'm certain that R.N. Elliott adopted the concept to explain waves with corrections of a magnitude that seemed to imply they were of the same degree, even when the wave count, with its rule about a third wave not being shorter than both the first and fifth waves of the same degree, said otherwise.

But Elliott didn't need the concept. His theories provide no rigorous definition of what constitutions a proper correction of any degree. We expect corrections to be proportional to others within a degree, but we can't explain what that means -- we know it when we see it.

I find it more useful to simply drop down a degree and keep on counting when poor differentiation encounters the third-wave rule. That's the method that I've used in counting subdivisions to wave 3 and wave 5 {-2}.

Click on chart to enlarge.
LUV 20 years monthly bars (left), 3 years 3-day bars (right)
Of course, that method does force me to squeeze a large numbers of degrees onto the chart. On the three-year chart, to the right, I show LUV as being in third, or middle, waves at the {-4} and {-3} degrees that cover price movements so far this year, in the fifth, or final, waves at the {-2} and {-1} degrees that cover the last two years, and then in third waves the rest of the way up to the {+3} degree.

That's a long way of saying that LUV has far more upside potential in its future than it does downside.

Because of those facts on the chart, I'm looking at LUV in two ways in this analysis, both as a leveraged play under my shorter-term rules and as a hedged play under my longer-term rules.

Options are pricing in confidence that 68.2% of LUV's trades will fall between $23.21 and $26.69 over the next month, for a potential gain or loss of 7%, and between $24.11 and $25.79 over the next week. I've marked those levels on the right-hand chart in blue.

Longer term, options are confident that 68.2% of trades over the next year will fall between $18.91 and $30.99 for a potential gain or loss of 24.2%. I've marked those levels in violet.

At the shorter-term level of trading, I'm mainly concerned about the end of wave 5 {-1}, which began July 3, 2013 from $12.58. The next major correction will retrace a portion of that doubling in the price of the stock.

Some common Fibonacci retracement levels for that rise would be 38.2% ($20.30), $50% ($18.83) and 61.8% ($17.35).

That decline will be triggered with the end of the {-3} degree, which began Dec. 4, 2013 from $17.73. It is presently in its third degree, beginning Jan. 27, 2014 from $20.22.

Longer term, my concern is with the rise beginning Oct. 4, 2011 from $7.15 as wave 3 {+2}. The end of that wave would prompt a somewhat larger correction with these common retracement levels: 38.2% ($18.22), 50% ($16.11) and 61.8% ($14.00).

It's difficult to estimate a "typical" length for waves at these degrees because of the extension. At the {-2} degree, the first wave was over in less than a month. The fifth wave is now in its fifth month of life. What Elliott called "extended waves" can go on for quite a long time, or they can come to a halt tomorrow. Thee's way to tell.

However, the difference between the shorter-term and longer-term retracements is not really that much, so even for a longer-term trade, the retracement of the {-2} degree is no minor matter.

Odds and Yields

LUV has completed nine bull signals since wave 3 {+2} began in October 2011. Five of them were successful, on average yielding 20.1% over 58 days. Four were failures, on average losing 7.3% over 68 days. The signals have an impressive win/lose yield spread of 12.8%.

One bull signal has been completed in the near-term rise that began last December as wave 5 {-2}. It was successful, gaining 17.8% over 68 days.

The numbers tell me that historically, LUV has had less than even odds of whipsawing, and its winning bull plays have been profitable enough to be worthe the risk.

The Company

Southwest Airlines, headquartered in Dallas, Texas, is the world's largest low-cost airlines, operating more than 3,400 flights a day to destinations in 42 states and Puerto Rico. It is the fourth largest U.S. carrier.

The airline industry is crowded and cutthroat, with price being a major arena of competition. This is a commodity-like market that harms profits.

Analysts seem quite satisfied with Southwest's ability to earn a buck, however, collectively coming down at a 43% enthusiasm level.

The reports return on equity of 12% -- lower than I like -- with debt amounting to 36% of equity -- higher than I like.

Southwest's earnings yield is 4.78%, lower than 73% of other airlines. That compares with a 2.61% yield on the 10-year U.S. Treasury note.

The company pays a dividend yielding 0.64% annualized at today's prices. It amounts to 13% of the earnings yield.

Earnings and growth imply a price of $27.74 for the stock, suggesting that it is undervalued by 10%. I've marked that price level on the right-hand chart as a red dashed line.

The stock is priced at 21 times earnings but at a slight discount to sales. It takes 97 cents in shares to control a dollar in sales.

The company has lost money in one quarter during the past three years, the 1st quarter of 2013.

Earnings tend to peak in the 2nd quarter, and that quarter's earnings has exceeded its year-ago counterpart the past two years. The last two quarters of 2013 and the first of 2014 have all come in well above their year-ago counterparts.

Southwest's earnings have surprised to the downside only once in the past three years, back in 2011, and has surprised to the upside the other 11 quarters of that period.

Institutions own 80% of shares.

Southwest next publishes earnings on July 24. The stock goes ex-dividend in June for a quarterly payout of four cents per share.

Liquidity and Volatility

LUV on average trades 5.4 million shares a day and supports a wide selection of option strike price spaced a dollar apart, with open interest runing to three figures near the money.

The front-month at-the-money bid/ask spread on calls is 7.7%, a bit wide but still something I can work with. That's compared to a 0.3% spread on the exchange-traded fund SPY, the most-traded symbol on the U.S. markets.

Implied volatility stands at 24%, compared to 12% for the S&P 500, and has been on the decline from 32% since April 11.

The volatility level is low, at the 31st percentile of the one-year range, suggesting that long option spreads bought with a debit have the greatest chance of success.

Call options are trading actively today, with volume running at more than 2-1/2 times their five-day average volume. Puts are running at only 53% of average volume.

Decision for My Account

I intend to open a bull position in LUV under my shorter-term rules. The fact that the subdivisions of the {-2} degree are third waves is persuasive, as is the fact that earnings growth implies that LUV is undervalued.

I'll place the trade in the half hour before the closing bell if LUV shows upward momentum. If momentum falters, then I'll add it to my Watchlist for later consideration.

I'm rejecting LUV as a trade under my longer-term rules. The airline industry's profits are always under pressure, and accidents in flights can cause the sort of bad publicity that causes stocks to drop.

Also, I'm not seeing much of a trend in LUV's profits. Trading coaches like to say that "the trend is your friend", and they're talking about prices. For longer term positions, I do indeed believe in the friendly trend, but I'm talking about earnings.

Is a business model based on being the least expensive airline flying really a way to ensure steadily rising profits? I think not.


My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.

No comments:

Post a Comment