The Spread Trader: Bear Put Spread On United Parcel Service (UPS)
Last week we got more bad news on the state of the US economy. Five of the nine economic indicators came in weaker than expected.
For instance, initial jobless claims and continuing claims both came in higher than expected… while housing starts and existing home sales fell short of expectations.
But the one that was most shocking was the Philly Fed’s Business Outlook. The indicator showed manufacturing activity contracted for a second month in a row.
The index fell to a reading of -16.6 in June. It was far below expectations of 0 and the lowest reading since last August.
It’s a continuation of an ugly trend of weaker than expected economic data. And more importantly, it’s a clear indication of slowing economic growth.
Obviously, slowing growth is bad for stocks. And it’s especially hard on cyclical stocks.
Cyclical stocks rise and fall with the business cycle. They typically outperform other stocks when growth is accelerating. And they fall further when economic growth is slowing.
One cyclical stock I’m expecting to get hit hard over the next few months is United Parcel Service (UPS).
As you know, UPS delivers packages.
Obviously, the number of packages they ship is tied to economic growth. They ship more packages when the economy is growing and fewer when the economy is slowing.
Right now, UPS is expected to grow revenue and earnings this year like the economy is still cruising along. But the economic data shows growth is slowing.
Simply put, something has to give.
Either the economic data needs to improve in a hurry or UPS’s revenue and earnings growth estimates need to be revised lower.
At this point, it appears economic growth is slowing and UPS’s growth estimates need to be dialed back. And negative revisions to growth almost always lead to a lower stock price.
This looks like a great opportunity for a bear put spread on UPS. This bearish strategy is made by buying one put option and selling another put option at a lower price.
Here’s what to do now…
Buy the UPS October 2012 $75 put for $2.80 and sell the UPS October 2012 $70 put for $1.42.
Remember, when buying a put spread, the maximum profit is the difference between the strike prices minus the amount paid for the spread.
This trade costs us $138 ($280 – $142) per contract. Our breakeven on the trade is $73.62. If UPS is trading at exactly $73.62 on October 19th, we’ll get our $138 back.
We’ve also limited our risk to our initial $138 investment. If UPS is trading above $75 on July 20th, we’ll lose $138. But no matter how high UPS goes, we can never lose more than our initial investment.
Now for the good part… profits!
Our maximum profit of $362 comes if UPS is trading at or below $70 on October 19th.
In other words, we’re risking $138 for a chance to make $362. And according to our tracking system, there’s a 33% chance of this trade making money. That’s a good risk/reward in my book.
Good Investing,
Corey Williams
Category: The Spread Trader
