Options Update: Caterpillar Draws Bullish Credit-Spread Attention

With Wall Street bathed in red today, Dow Jones Industrial Average (DJIA) component Caterpillar
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has followed suit.

The shares made an early run at short-term resistance near the 38 level, but the stock has since pulled back more than 1.5%. The headlines are devoid of reports for the construction specialist, but this lack of news hasn’t deterred options traders, who have piled into the stock’s December puts.

This attention to put options runs against the grain for CAT, as the equity’s Schaeffer’s put/call open interest ratio (SOIR) of 0.98 ranks below 91% of all those taken during the past year. Looking at our Intraday Volume Explosion List, it seems that speculative options traders are having a change of heart, as more than 32,000 puts have changed hands on the security so far. This wealth of activity has easily outpaced CAT’s average daily put volume by more than 5 to 1.

The Anatomy of a Caterpillar Bull Put Credit Spread

Digging into the activity, I discovered that 2 large blocks of 15,000 contracts traded on both the December 30 put (CAT XF) and the December 35 put (CAT XG) at about 9:43 a.m. Eastern time. The CAT XF contracts changed hands at the ask price of $0.76, while the CAT XG contracts traded at the bid price of $1.84. With the blocks trading at the same time on the same exchange, I can reasonably assume that these trades are related. In fact, it appears that we are looking at a neutral-to-bullish credit spread on CAT.

Caterpillar volume details

A bullish credit spread involves selling a higher-strike put and purchasing a lower-strike put. This results in a net credit to the investor’s account. The maximum profit is achieved as long as the sold put stays out of the money by expiration. In today’s example, the trader needs CAT to stay above the 35 level by the close of trading on December 19, when these options expire.

So, how does today’s example work on paper? First, the trader purchases the CAT XF puts for a debit of $1,140,000 — ($0.76*100)*15,000 = $1,140,000. Next, the trader sells the CAT XG puts for a credit of $2,760,000 — ($1.84*100)*15,000 = $2,760,000. A total credit of $1,620,000 for the position is arrived at by adding the credit received from selling the December 35 and the debit incurred for purchasing the December 30 puts — ($2,760,000 – $1,140,000 = $1,620,000).

Hedging Your Bets

So, why not just sell the December 35 puts outright and collect the entire $2,760,000 premium? Well, the purchased December 30 puts act as a form of insurance against an unexpected plunge in the position. Once CAT breaches the 35 level, the sold 35 put becomes a liability, and continues to lose money until the shares breach the purchased 30 put.

By entering this trade, the investor is indicating that he expects CAT to hold above the 35 level for the next several weeks. The shares are holding their ground in today’s trading, 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, the stock has dropped more than 49% on a year-to-date basis, edging out the S&P 500 Index’s (SPX) loss of nearly 42% for the same time frame. Losses have accelerated during the past couple of months, with CAT falling 58% since mid-May. During this time frame, the shares have battled overhead resistance at their 10-week and 20-week moving averages. In recent weeks, CAT has trended sideways between support at the 32 level and resistance in the 40 region. This sideways action doesn’t detract from a bull-put credit spread, with the exception that the lower rail of this channel rests 3 points below the sold 35 put. If the shares fail to establish a higher baseline than the 32 level, the aforementioned credit spread could be called into question.

Weekly chart of Caterpillar since May 2008 with 10-week and 20-week moving averages

The Sentiment Drivers

On the sentiment front, the outlook is mixed for CAT. The stock’s exceedingly low Schaeffer’s put/call open interest ratio (SOIR) of 0.98 in the 9th percentile of its annual range points to a wealth of optimism from options traders. An unwinding of this bullish sentiment could increase selling pressure on the shares.

Meanwhile, Wall Street analysts are betting heavily against CAT. According to Zacks.com, 13 of the 18 analysts following the security rate it a “hold” or worse. This configuration provides ample room for potential upgrades, which could prove beneficial to a bull-put credit spread.

Sentiment indicators for Caterpillar

The Verdict?

As goes the economy, so goes Caterpillar. The recent plunge in crude-oil prices should offer some support for a firm that specializes in heavy construction equipment, but the downturn in the global economy could more than make up for the perceived benefit of lower fuel costs. As such, it could take considerable good news on the economic front before any of the brokerage firms on Wall Street consider upgrading the security. Meanwhile, a resumption of the stock’s downtrend could prompt an unwinding of bullish sentiment in the options pits. By that time, however, the aforementioned bull-put credit spread would already be a liability.

The profitability of this position hinges on technical support and a lack of any major negative economic developments before December options expire. The gamble could payoff handsomely if CAT can find the needed support, but with fresh concerns about a recession arriving on a daily basis, this trade looks extremely risky at the moment.

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