During the 39-day lifespan of the position, shares gained 8.6%, for an 80.3% annual rate.
The options produced a 100% yield on debit, or a 935.9% annual rate.
Update 12/8/2014: I've opened the bull position in MNK as described below in the "Decision" section. In order to get a fill, I had to drop my asking price to the point where the risk/reward ratio was raised to 2.4:1.
The Irish pharmaceutical house Mallinckrodt PLC (MNK) has a short history as an independent company. Merging its chart with that of its parent, I try to puzzle out how far Mallinckrodt's Ride has proceeded along its bullish course, and how much lies ahead.
The Chart
MNK is the new kid on the block, having gone public only a bit more than a year ago, on July 1, 2013, with an opening price of $45.94. The price has doubled since, but the chart is difficult to analyze because it shows so little history.
Any time a company enters the markets for the first time, it is sneaking into a play long after the curtain has gone up.The plot line springs from the pre-IPO backstory that often remains largely hidden from traders, and the scenery is the company's sector whose history may well date back a century or more.
We enter MNK's play as the characters, clad in the costumes of the ancient Celts, chat casually amidst a sideways trend. Suddenly, the stage is filled with action, point and counterpoint, ups and downs for the brave Chieftains Mallinckrodt and their hardy band of warriors, in a dramatic flurry that has not yet faltered.
Shakespeare's approach was similar, where the play begins with two minor characters discussing the great and powerful who will soon fill the stage with Sturm und Drang.
The problem for me as an Elliott wave analyst is that I lack the context to understand what's really going on. Is the drama a concluding battle of great import, or merely a skirmish along the way. Is it a 3rd wave to the upside or a 5th? Is it part of a greater uptrend or merely a countertrend correction within a larger downtrend?
MNK, as it turns out, was spun off in 2007 from another Irish company called Covidien PLC (COV), providing a way for us to get some answers to those questions, however imperfect.
The caveat is that a combined company is not identical with the spun-off company, and so the histories pre- and post-separation are apples and oranges, defying a direct comparison. However, the close tie does give COV's chart some weight in understanding MNK's.
Click on chart to enlarge.
 |
| COV 8 years 4 months weekly bars (left), MNK 1 year 5 months daily bars (right) |
During the period prior to the spin off, COV (left chart) was beginning a 3rd wave within a 3rd of greater degree within an uptrend that began with the 2009 Great Recession low.
After the spin-off, MNK (right chart) followed COV in a sideways move for several months before taking off in what appeared to be wave 5 {+1}. That 5th wave, in turn, is within its middle, or 3rd wave, which in turn began its 5th and final wave in October.
A correction to the downside is on the horizon. It will take back a portion of the wave 3 rise that began in April from $56.12. That is a significant downturn, potentially, and it is a risk that I would take only if my exposure were for a short period of time.
Despite the risk, there is no doubt that MNK is in an uptrend and is best played with a bullish strategy.
Odds and Yields
MNK has completed three breakouts since wave 3 began in April. Two were successful, on average yielding 12.4% over 42 days. The unsuccessful trade lost 6.9% over 17 days. The success rate is 67% with a positive 5.5% win/lose spread that promises a reasonable chance of profit if MNK stays true to its history.
The Company
Mallinckrodt, headquartered in Dublin, develops and manufactures pharmaceuticals, both branded and generic. It is the largest U.S. supplier of pain medications that act similarly to morphine and other opiates. It maintains a U.S. headquarters in St. Louis, Missouri.
Analysts are quite optimistic about Mallinckrodt's prospects, coming down collectively at a positive 33% enthusiasm rating.
The company reports return on equity of 15%, with debt running at 80% of equity. Those figures leave Mallinckrodt short of qualifying as a growth stock according to my criteria.
Earnings have been profitable in all of the six quarters since the company was spun off, with an rising trend the two most recent quarters.
All but one quarter have produced upside surprises. The downside surprise was in the first quarter after the spinoff last year.
The earnings yield is 4.89%, compared to a 2.28% yield on 10-year U.S. Treasury notes. The company pays no dividend.
The "fair" price implied by earnings growth estimates is $134.20 per share, compared to the market price of $96.35 per share. The market is discussing shares by 29% below the implied price.
The stock is selling at 21 times earnings and also at a large premium to sales. It takes $4.81 in shares to control a dollar in sales.
Institutions own 91% of shares.
Mallinckrodt next publishes earnings on Feb. 4.
Liquidity and Volatility
MNK on average trades 18 million shares a day and supports a moderate selection of option strike prices spaced $5.00 apart., with open interest running at four figures.
The front-month at-the-money bid/ask spread on calls is 8.5%, compared to 0.7% on the most traded symbol on the U.S. markets, the exchange-traded fund SPY.
Implied volatility stands at 40%, compared to 14% for the S&P 500 index, and has been trending sideways in a series of swings since mid-Novemver. MNK's volatility is in the 61st percentile of its rise to a high of 44% attained on Dec 3.
That level of volatility implies that the most profitable trades will be structured as short option spreads, sold for a credit and expiring in a front month or sooner.
Options are pricing in confidence that 68.2% of trades will fall between $85.12 and $107.32 over the next month, for a potential gain or loss of 11.5%, and that 95% will fall between $74.02 and $118.42.
Options are trading briskly on the call side, which is running at 14% above five-day average volume. Puts are at 78% of average.
Decision for My Account
The fact that implied volatility stands above 60% means that I can play MNK as a quicker trade. With earnings season beginning anew on Jan. 8, I'm wanting to avoid new longer-running positions that will tie up my free cash, with a potential for lost opportunity.
MNK has Weeklys in its options inventory. However, they lack sufficient open interest to support a trade and carry huge bid/ask spreads. So the shortest position I can manage is the regular monthly series expiring Jan. 15, which carries me into the earnings season but only by a week.
That short a commitment makes up for the correction I see looming on the chart. Although MNK is in the final wave, 5 {-1} of its rise from April, that wave is in wave 3 {-2} internally, meaning it has room to rise.
I intend to structure the position as bull put options spreads, short the $95 puts and long the $90 puts, sold for a credit and expiring Jan. 15. The $5 spread between strikes increase the risk/reward ratio, and the best probability of expiring out of the money that I can obtain is 52.4%. I prefer to be in the 60s or 70s but I've taken near-even odds before, and the tilt is at least slightly in my favor.
Practically speaking, the risk means I'll need to jump out at the first sign the trade is going against me.
The position carries a 2.3:1 risk/reward ratio. The leverage is 2.2:1.
I'll place the trade in the half hour prior to the closing bell if MNK continues to show upward momentum. If MNK falters, then I'll place it on the Watchlist for later consideration. In either case, I'll update this report with the outcome.
-- Tim Bovee, Portland, Oregon, Dec. 8, 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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