Options Update: Caterpillar Buried Under Heavy Put Volume

Shares of blue-chip construction equipment firm Caterpillar
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plunged more than 13% last week, as traders reacted to the company’s lackluster earnings report and massive job cuts.

On Friday, CAT increased its pink-slip collection, adding 2,110 new job cuts to its previously announced 20,000 cuts. Today, the shares are off more than 1.5%, as the stock tagged its third consecutive 52-week low.

Looking to speculate on a continued decline in CAT shares, options traders have piled into puts today. So far, more than 36,000 CAT puts have crossed the tape, more than tripling the stock’s average daily put volume and placing the shares on our Intraday Volume Explosion List. Nearly all of this activity was centered at the February 25 and February 30 strikes. The vast majority of the February 25 puts changed hands at the bid price, while the February 30 puts mostly traded at the ask price. This activity appears to be a bearishly oriented spread.

Caterpillar option volume details

The Anatomy of a Caterpillar Put Position

Looking at the chart above, you can see that practically all of CAT’s February 25 put volume changed hands at the bid price. In fact, the 10,897 contracts highlighted in the chart all traded within seconds of each other on the same exchange and were marked “spread,” suggesting they were all part of a larger position. Assuming these blocks are related, the total credit received from this position would be $227,474.88 — (0.21 * 100)*10,897 = $227,474.88.

The second half of the spread traded on the February 30 put, with 10,897 contracts crossing the tape at the average ask price of $1.38. The total debit for this half of the trade would be $1,501,061.75 — ($1.38 * 100)*10,897 = $1,501,061.75. By subtracting the credit received for selling the February 25 puts from the debit incurred by buying the February 30 puts, we arrive at a total cost for the position of $1,273,586.88 — $1,501,061.75 – $227,474.88 = $1,273,586.88.

If the trader in today’s example doesn’t own the shares, then CAT would need to drop about 6.5% to $28.83 per share from the stock’s Friday close of $30.85 before the options expire on Feb. 20 in order for this position to reach breakeven. The maximum loss on this position is limited to the difference between the debit incurred on the February 30 put and the credit received for the February 25 put, or $1,273,586.88. Breakeven, meanwhile, is lifted by about 21 cents per share due to the premium received from the sold put. Finally, the trade reaches its maximum profit potential when CAT falls to $25 per share.

By entering this trade, the investor is indicating that he expects CAT to decline steadily in the coming weeks prior to February expiration. The position has started on the right foot, but let’s see if the stock’s technical or sentiment backdrops provide any additional drivers for this trade.

Getting Technical

From a technical perspective, CAT has been locked in a steady decline since May 2008. During this time frame, the shares have fought a losing batting against their 10-week and 20-week moving averages. In fact, the security’s most recent rejection at its 20-week trendline has forced CAT to test potential round-number support at the 30 level. The equity has not traded south of $30 per share since July 2003. More importantly, however, was CAT’s recent breach of the 32 level. This area marks the stock’s November-December 2008 lows, as well as a gap higher in the equity in July 2003. As such, CAT’s break with this long-term support level could signal that selling pressure has yet to be exhausted.

Weekly chart of Caterpillar since July 2003 with 10-week and 20-week moving averages

The Sentiment Drivers

Sentiment toward CAT is mixed, with short sellers and analysts betting heavily against the shares. Specifically, 13 of the 17 brokerage firms following the shares rate them a “hold” or worse. Meanwhile, short interest jumped 22% during the most recent reporting period to account for 5.6% of the stock’s total float. Both short sellers and analysts still have room to increase their bearish stance on CAT, however, and the stock’s technical backdrop offers little reason for these naysayers to change their positions at this point.

On the other hand, options traders are heavily optimistic toward CAT. The stock’s Schaeffer’s put/call open interest ratio (SOIR) of 1.02 ranks below 83% of all those taken during the past year. Furthermore, the International Securities Exchange and Chicago Board Options Exchange’s 10-day call/put ratio ranks above 71% of the past year’s readings, underscoring the preference for bullish bets from this speculative group of investors. This wealth of optimism bodes ill for CAT from a contrarian perspective.

Sentiment indicators for Caterpillar

The Verdict? Given the poor technical performance, weakening global manufacturing data, and lingering optimism among investors, I really like the prospects of a put, or short, position on CAT at the moment. However, I am still not quite certain why the investor in today’s trading example would cut his/her profits short by selling the February 25 put. Why not just buy the February 30 put (or, better yet, the March 32 put), and let CAT implode during the next several weeks?

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.