The Spread Trader: Bull Call Spread On Caterpillar (CAT)
So far the Fed’s latest action hasn’t made a big impact on stock prices. In fact, the markets have been trending modestly lower after an initial surge higher in the first days following the announcement of QE3.
What’s behind the markets sluggish performance?
Put simply, weak economic data.
Despite the introduction of QE3, economic data indicates global economic growth is slowing. As you know, when growth is slowing on a macro level, it’s difficult for companies to live up to their own growth estimates.
One of the areas hardest hit by the weak economic outlook is construction and mining equipment. Just last week, industry bellwether Caterpillar (CAT) slashed their 2015 earnings outlook from $15 to $20 per share to $12 to $18 per share.
Not surprisingly, the announcement sent CAT’s stock tumbling lower.
But here’s the thing… I think the reaction was overblown.
First off, new home construction in the US has finally reached a turning point. As home builders get back to work, they’re going to need lots of new equipment.
What’s more, CAT could get a boost from sales in China as well.
Don’t forget, CAT already has a massive operation in China. And they just announced a $160 billion infrastructure stimulus plan. They plan to build highways, ports, and other transportation structures. And those types of projects require lots of heavy equipment.
Here’s the bottom line… the company is holding firm to their 2012 guidance. And there’s a good chance the company can outperform expectations in 2013 and 2014.
So, the recent selloff based on their lower projections for 2015 could be a great buying opportunity. Just take a look at this chart…
As you can see, the recent announcement has sent CAT tumbling from a recent high of $94.23 to $85.89 today. But the stock is still in an uptrend off the July lows.
Right now, CAT is testing the support zone (green line) of the uptrend. And if it holds, we’ll likely see it rally back to the resistance of the channel line (red line).
This looks like a great opportunity to pocket some quick profits on a bull call spread on CAT. This bullish strategy is made by buying one call option and selling another call option at a higher price.
Here’s what to do now…
Buy the CAT November 2012 $90 call for $1.66 and sell the CAT November 2012 $95 call for $0.54.
Remember, when buying a call spread, the maximum profit is the difference between the strike prices minus the amount paid for the spread.
This trade costs us $112 ($166 – $54) per spread. Our breakeven on the trade is $91.12. If CAT is trading at exactly $91.12 when the options expire in November, we’ll get our $112 back.
We’ve also limited our risk to our initial $112 investment. If CAT is trading below $90 at the November options expiration, we’ll lose $112. But no matter how far CAT falls, we can never lose more than our initial investment.
Now for the good part… profits!
Our maximum profit of $388 comes if CAT is trading at or above $95 at November options expiration.
In other words, we’re risking $112 for a chance to make $388. And according to our tracking system, there’s a 30% chance of this trade making money. That’s a good risk/reward in my book.
Good Investing,
Corey Williams
Category: The Spread Trader
