Ensco plc (ESV) has been in a sharp downtrend since last year, amid a slide in crude oil prices, and accelerated its decline beginning in June, creating potential for a profitable bear play.
The Chart
ESV, in common with most companies, peaked in 2008 and then collapsed into a 2009 low. I've counted it as a downward countertrend correction, with the Elliott wave A-B-C pattern. It could just as well prove to be the first three waves of a downtrend, with the 1-2-3-4-5 wave pattern, providing more downside potential Time will tell. At this degree, a lot of time.
Click on chart to enlarge.
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| ESV 10 years weekly bars |
Odds and Yields
ESV has completed seven breakouts since wave C {+3} began in February 2013. Six were successful, on average yielding 4.8% over 54 days. The unsuccessful trade lost 6.6%% over 13 days, on average.
The Company
Ensco is second-larger offshore drilling company in the world, with its operational headquarters in Houston, Texas (although it is incorporated in London).
Analysts are quite negative about Ensco, coming down collectively at a negative 86% enthusiasm rating.
The company reports return on equity of 12%, with debt running at 50% of equity, a high level.
Earnings have been profitable in each of the past 12 quarters.
Eleven quarters have produced upside surprises. The most recent downside surprise was the last quarter of 2013.
The earnings yield is 6.43%, compared to a 2.2% yield on 10-year U.S. Treasury notes. The dividend yield is 8.95% annualized at today’s prices.
The "fair" price implied by earnings growth estimates and the dividend is $132.09 per share, compared to the market price of $33.51 per share. The market premium is 75% below the implied price. If the high dividend is removed from the equation, then the "fair" price is $84.70, and the market is undervaluing ESV by 60%.
The stock is selling at 16 times earnings and also at a premium to sales. It takes $1.79 in shares to control a dollar in sales.
Ensco next publishes earnings on Feb. 17. The stock goes ex-dividend on Dec. 4 for a quarterly payout of 75 cents per share.
Liquidity and Volatility
ESV on average trades 3.7 million shares a day and supports a wide selection of option strike prices spaced a dollar apart, with open interest running from three to four figures.
The front-month at-the-money bid/ask spread on puts is 7.3%, compared to 0.4% on the most traded symbol on the U.S. markets, the exchange-traded fund SPY.
Implied volatility stands at 45%, compared to 13% for the S&P 500 index, and is began a sharp rise on Friday after pulling back from the peak. ESV's volatility is in the 94th percentile of its rise to a high of 47% attained on Oct. 14.
That level of volatility implies that the most profitable trades will be structured as short option spreads, sold for a credit and expiring in December.
Options are pricing in confidence that 68.2% of trades will fall between $29.40 and $38.18 over the next month, for a potential gain or loss of 26%, and that 95% will fall between $25.02 and $42.56.
Options are trading on the briskly today, with calls running at nearly 4 times their five-day average volume and puts at 2-1/2 times average.
Decision for My Account
I see this as a reasonable trade under my shorter-term rules. My one reservation is that today is a shortened post-holiday session of the markets.
I'll place the trade prior to the closing bell, at 1 p.m. New York time today, if downward momentum continues and if I can get a good fill to my order. Otherwise, I'll try again on Monday.
I intend to structure the position as a bear call spread, short the $36 calls and long the $37 calls, sold for a credit and expiring Dec. 19.
The resulting risk/reward ratio is 5.6:1, somewhat higher than I like. A higher ratio reduces my profit within my trade sizing rules, requiring me to either pass on the trade or to increase its size in order to get adequate dollar return. I'm choosing to double the size from that required by my rules.
The trade leaves a portion of the one standard deviation range, covering 68.2% of trades, unprotected to the upside. However, it was impossible to increase the coverage without also increasing the risk to u workable levels.
The probability of the short calls expiring out of the money is 76%.
The leverage is 1:3.
-- Tim Bovee, Portland, Oregon, November 28, 2014
References
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.
From time to time 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.
Disclaimer
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.License
All content on Tim Bovee, Private Trader by Timothy K. Bovee is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License.
Based on a work at www.timbovee.com.
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