New Option Plays
by OI Staff
Caterpillar - CAT - close: 92.78 change: +0.72 stop: 90.50
For more than 75 years, Caterpillar Inc. has been building the world's infrastructure and, in partnership with its worldwide dealer network, is driving positive and sustainable change on every continent. With 2004 sales and revenues of $30.25 billion, Caterpillar is a technology leader and the world's leading manufacturer of construction and mining equipment, diesel and natural gas engines and industrial gas turbines. (source: company website)
Why We Like It:
We like CAT because the bounce has been pretty convincing. Earnings weren't so hot but traders bought the dip in late January just as CAT touched its 100-dma, which just happened to coincide with the 38.2 percent Fibonacci retracement level of its August to December rally. Now after more than a week of consolidating sideways between $90 and $93 the stock is challenging resistance at its 50-dma. We want to use a TRIGGER above minor resistance at $94.00 to catch the next leg higher. Our strategy will be to buy calls as CAT trades at $94.05. Our short-term target will be the $99-100 resistance levels.
We are suggesting the March and May calls.
BUY CALL MAR 90 CAT-CR OI=2079 current ask $4.30
BUY CALL MAR 95 CAT-CS OI=2138 current ask $1.50
BUY CALL MAY 90 CAT-ER OI=8315 current ask $5.80
BUY CALL MAY 95 CAT-ES OI=5978 current ask $3.20
Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 01/27/05 (confirmed)
Average Daily Volume = 2.4 million
KMRT 103.02 110.00-115.00 98.50 *new playKmart Holding - KMRT - close: 103.02 chg: +3.30 stop: 98.50
Kmart Holding Corporation and its subsidiaries (together, "Kmart") is a mass merchandising company that offers customers quality products through a portfolio of exclusive brands that include Thalia Sodi, Jaclyn Smith, Joe Boxer, Kathy Ireland, Martha Stewart Everyday, Route 66 and Sesame Street. (source: company website)
Why We Like It:
It appears that the momentum traders are back in KMRT. Shares broke down sharply in January but the selling abruptly stopped once KMRT neared the 61.8 percent Fibonacci retracement of its August to November rally. The recent breakout back over the $100 level is very bullish and after four days of consolidating that breakout traders are back to buying the dip. It's probably no coincidence that Friday's bounce is off the old trendline of lower highs (see chart). KMRT looks poised to run again. The P&F chart is very bullish with a $143 target. We are only targeting a short-term move to the $110-115 range.
We are suggesting the March and we plan to exit before KMRT's earnings report mid-month.
BUY CALL MAR 95 KTQ-CS OI= 2519 current ask $9.80
BUY CALL MAR 100 KTQ-CT OI=10835 current ask $6.20
BUY CALL MAR 105 KTQ-CA OI=14143 current ask $3.50
BUY CALL MAR 110 KTQ-CB OI= 6459 current ask $1.75
Picked on February 13 at $103.02
Change since picked: + 0.00
Earnings Date 03/16/05 (unconfirmed)
Average Daily Volume = 2.5 million
In Play Updates and Reviews
by OI Staff
Cooper Industries - CBE - close: 69.77 chg: +0.37 stop: 67.49
CBE is one of the 63 S&P 500 components that has raised its dividend this year. CBE raised their cash dividend from 35 cents to 37 cents a quarter with the next one payable on April 1st. While this is good news for shareholders we doubt it's going to move the stock price and it doesn't matter to option traders. Currently we remain defensive. The breakdown back under the $70 level this week and Friday's apparent failed rally to get back over it doesn't bode well. Technicals are mixed with the MACD indicator suggesting a new sell signal soon. There is still a strong possibility that CBE will pull back to support near $68 before bouncing again but we would hesitate to add new long positions until after we see that bounce.
We like the April 65 and 75 calls but wait for CBE to finish pulling back and then look for the bounce.
Picked on February 03 at $ 70.01
Change since picked: - 0.24
Earnings Date 01/25/05 (confirmed)
Average Daily Volume = 436 thousand
eBay Inc - EBAY - close: 82.07 chg: +0.85 stop: 76.94
Our EBAY play is off to a decent start. Shares added another one percent on Friday following Thursday's bullish breakout over the $80 level. EBAY's P&F chart has also reversed from a bearish signal into a new bullish double-top breakout buy signal with a $93 target. Looking more closely at EBAY's intraday chart you can see that traders bought the early morning dip and again at the afternoon dip. Piper Jaffray came out on Friday to reiterate their "market perform" rating while issuing some cautious comments to go along with their lowered price target from $101 to $95. Our target remains the $87.50 region.
This is likely to be a short-term four-to-six-week play. We're suggesting the March calls.
BUY CALL MAR 75 XBA-CO OI= 6247 current ask $8.50
BUY CALL MAR 80 XBA-CP OI= 9144 current ask $5.00
BUY CALL MAR 85 XBA-CQ OI=14746 current ask $2.55
Picked on February 10 at $ 81.22
Change since picked: + 0.85
Earnings Date 01/19/05 (confirmed)
Average Daily Volume = 13.8 million
Hartford Financial - HIG - cls: 73.76 chg: +2.28 stop: 69.00 *new*
The IUX insurance index has been very strong this week as a number of large insurers have reported strong earnings and/or raised their dividends. HIG, after three days of consolidating last week's breakout over major resistance, finally got in on the insurance sector's breakout act and added 3.18 percent on Friday to market new four-year highs. HIG looks very strong here but we still expect some minor profit taking. Readers can look for a dip back toward the $72 level as a potential entry point. Short-term traders may want to consider taking some early profits here. The March $65 calls have risen from $6.60 to $9.10 (+37.8%) and the March $70 calls have jumped from $2.30 to $4.40 (+91.3%). Our target is still in the $78-80 range and we're going to raise our stop loss to $69.00.
We are going to suggest the March options although June options are available.
BUY CALL MAR 65 HIG-CM OI=1615 current ask $9.10
BUY CALL MAR 70 HIG-CN OI=1963 current ask $4.40
BUY CALL MAR 75 HIG-CO OI= 295 current ask $0.95
Picked on February 06 at $ 71.17
Change since picked: + 2.59
Earnings Date 01/26/05 (confirmed)
Average Daily Volume = 1.2 million
Invitrogen - IVGN - close: 72.21 chg: +0.56 stop: 69.95 *new*
It was a decent week for IVGN. The stock soared toward the top of its rising channel on February 8th following news that the company would buy privately held Dynal Biotech, which would boost IVGN's earnings results going forward. Unfortunately, Tuesday's rally fell short of our $75.00 target. Since then IVGN has pulled back in what can only be described as normal profit taking. We remain bullish but we're running out of time. IVGN is due to report earnings on Thursday, February 17th after the closing bell. Right now we're planning to close the play on Wednesday afternoon at the close to avoid IVGN's earnings report. Short-term traders may want to plan to exit now given the small gain in the stock. We are raising our stop loss to $69.95. We will also adjust our target to $74.80.
We are not suggesting new positions at this time.
Picked on January 27 at $ 70.05
Change since picked: + 2.16
Earnings Date 02/17/05 (confirmed)
Average Daily Volume = 800 thousand
RD Donnelley - RHD - close: 60.50 change: +0.29 stop: 57.95
Readers need to be ready! Last week's bullish breakout over round-number, psychological resistance at the $60 level is fading. Now normally it's pretty common to see a stock pull back and retest broken resistance as support. That's okay with us. Yet if the market suddenly falters then RHD could actually breakdown below the bottom edge of its rising channel. If RHD trades under the $59 level we'd probably consider exiting even though our stop loss is lower under the simple 50-dma.
This is a short-term momentum play and we plan to be out before the end of February. However, we do not see much volume in the March calls so we're going to suggest the May strikes.
BUY CALL MAY 55 RHD-EK OI= 338 current ask $6.90
BUY CALL MAY 60 RHD-EL OI= 498 current ask $3.40
BUY CALL MAY 65 RHD-EM OI= 127 current ask $1.25
Picked on February 03 at $ 60.76
Change since picked: - 0.26
Earnings Date 02/27/05 (unconfirmed)
Average Daily Volume = 186 thousand
Texas Industries - TXI - cls: 63.85 chg: +0.35 stop: 61.50 *new*
TXI continues to flirt with resistance at the $65.00 level. Fortunately for the bulls the stock is building a consistent pattern of higher lows, which is being bolstered by its rising 50-dma. This pattern should produce a bullish breakout over the $65 level but nothing is a guarantee. One thing is sure - the tighter TXI coils the sooner we'll see a breakout one way or the other. At this point in the game we are raising our stop loss to $61.50 and readers looking for new positions will probably want to wait until TXI trades over $65.50 before initiating plays. The P&F chart currently points to $74 but if TXI can trade over the $66 mark it will produce a new spread triple-top breakout buy signal.
February and March calls are available but we are suggesting the April strikes.
BUY CALL APR 60 TXI-DL OI= 80 current ask $5.80
BUY CALL APR 65 TXI-DM OI=135 current ask $2.90
BUY CALL APR 70 TXI-DN OI=112 current ask $1.25
Picked on January 09 at $ 60.18
Change since picked: + 3.69
Earnings Date 12/16/04 (confirmed)
Average Daily Volume = 238 thousand
Apollo Group - APOL - close: 76.43 chg: +2.41 stop: 80.11
Argh! APOL was performing wonderfully until Friday. The stock was under performing the broader indices and breaking down through support levels on Wednesday-Thursday this week. Then Friday morning Bear Stearns comes out with positive comments suggesting the recent weakness is a buying opportunity. APOL rallied 3.25 percent to erase Thursday's losses. The question is whether or not there will be any follow through to Friday's bounce. The stock still has resistance at the $80 level so we can watch for another failed rally as a new entry point.
Wait to see where APOL begins to roll over again before considering new positions. We like the March or May puts.
Picked on January 23 at $ 77.61
Change since picked: - 1.18
Earnings Date 12/16/04 (confirmed)
Average Daily Volume = 2.4 million
Nike Inc - NKE - close: 84.65 chg: +0.69 stop: 87.01
It's been somewhat of a volatile week for NKE. Shares gapped down under support at the $85 level and its 100-dma on Tuesday after Merrill Lynch downgraded the stock. Since then NKE has consolidated sideways and as of Friday is testing the $85 level and its 100-dma as resistance. It's possible that NKE could rally toward the $86 level to "fill the gap". If this does occur then readers can short a failed rally at $86.00. Of course we'd prefer to see NKE roll over under the $85 level. Technicals are mixed but the two-month trend is bearish. The P&F chart has produced a high-pole (bearish reversal) warning but it will take a drop under $82 to create a new sell signal. Our target is the $80 region.
We are suggesting the March or April puts.
BUY PUT MAR 85 NKE-OQ OI=624 current ask $2.40
BUY PUT MAR 80 NKE-OP OI=576 current ask $0.75
BUY PUT APR 85 NKE-PQ OI=1110 current ask $2.90
BUY PUT APR 80 NKE-PP OI=1138 current ask $1.10
Picked on February 08 at $ 84.55
Change since picked: + 0.10
Earnings Date 12/16/04 (confirmed)
Average Daily Volume = 1.1 million
Phelps Dodge - PD - close: 93.64 chg: +1.59 stop: 92.01
Metal and mining stocks have done pretty well the last few days and shares of PD have bounced with them the latter half of the week. Short-term technicals have turned bullish but we don't mind since we're still spectators. Our trigger to buy puts is at $89.90 to catch a breakdown under support at the $90 level. If PD closes above the $95 level we will drop this candidate from the put list.
We are not suggesting bearish positions at this time. Our trigger is a drop under $89.90.
Picked on February xx at $ xx.xx <-- see TRIGGER
Change since picked: - 0.00
Earnings Date 01/27/05 (confirmed)
Average Daily Volume = 2.2 millionNone today.
Repairing Losing Positions
by OI Staff
You did your homework. You drew trendlines, added moving averages and watched formations and oscillators. You practiced patience. Your favored stock finally hit the support you'd identified and bounced. You bought calls.
For a week, your play works spectacularly. The stock gaps almost four points higher and holds that level. You're a position trader and you check the value of the stock and your calls each afternoon just before the close. You consider taking profits since your calls have more than doubled, but it's doing so well and you vacillate.
Then late one Wednesday--not even a merger-and-acquisition Monday--you turn to your computer screen to find that your favored company will be acquiring another company. Investors didn't like the idea. The stock had gapped lower. The calls that had been bid at $5.25 the previous day, and for which you'd paid $2.41, dropped to a bid of $2.05.
First you lament your poor account management skills. You should have locked in that profit. Then you consider your three choices: averaging down, selling and taking the loss, or staying in and hoping for the best.
That's what happened to call buyers in Cimarex Energy (XEC), with the company deciding in January to acquire Magnum Hunter Resources. For most of a year, Cimarex had been bouncing from its 100-ema. Often CCI moves up through the zero line accompanied those bounces, corroborating them.
Traders who bought calls on each bounce could have profited. That's how it looked about January 12, too, when XEC began moving up again from the 100-ema. The gap looked like a breakaway gap, a gap as prices break out of a formation, and those often aren't filled, so traders might not have worried too much about the need for a gap fill. A week later, XEC gapped above $40.00, closed only part of the gap and began moving up again. Until XEC announced that acquisition Wednesday, January 26.
Traders in that situation might have had more than three choices, however. Note that XEC dropped only to the 100-ema, an average from which it usually bounced. If a long call owner believed that XEC might still bounce after a period of consolidation, other choices existed. It was time to pull out that copy of McMillan's OPTIONS AS A STRATEGIC INVESTMENT from the dusty bookshelf. McMillan discusses two other defensive strategies a call owner might employ to repair a losing position.
Before examining other strategies, it might be helpful to benchmark the loss that would have been incurred if the call had been sold and no further tactics explored. Assume a purchase of a March 35 call on January 12. No March 35 volume occurred that day, but the CBOE option calculator returns an estimated price of $2.41 per contract. For the purposes of this article, commissions will not be considered. Prices discussed here will be prices per contract, with the understanding that actual position costs must be multiplied by 100 to obtain the true cost. With those assumptions, the drop from the estimated January 12 cost of $2.41 for the March 35 call to the January 26 closing bid at $2.05 resulted in a $0.36 or 15 percent loss.
Estimated Cost of a March 35 call contract purchased on January 12 = $2.41
Bid Price for a March 35 call contract on January 26 = $2.05
Total Loss (cost minus price received) = $2.41-2.05 =$0.36 or 15 percent
That's not much of a loss. Conservative traders might have elected to take that minimal loss and step away until XEC sorted through the news. However, XEC's news-driven move does allow for an examination of real-life defensive strategies.
The first defensive strategy McMillan offers for consideration is the rolling-down strategy. To employ this strategy, two March 35 calls would be sold and one March 30 (or lower strike) bought. The trader would now be short one March 35 call and long one March 30. This strategy creates a bull call spread. It would be employed only if the trader believed that XEC would likely steady and climb again into March expiration.
McMillan imposes a condition for considering this strategy. Enough money must be made on the sale of the two higher-priced calls to recoup most or all the cost for the lower strike call. The option chain from January 26, shown above, demonstrates that the condition could not be met in this real-life situation. The March 30 was too expensive.
For simplicity, assume that sold options are sold at the bid and purchased options are purchased at the ask, although some effort might be made to split the difference in real-life situations. Under this assumption, selling two March 35 calls would have brought in $4.10 (2 X $2.05 bid) while buying one March 30 would cost $6.40. The credit received from the sale did not come close to paying for the March 30 call.
That's not going to meet McMillan's parameter, so this strategy must be rejected. However, for the sake of examining the strategy, imagine that figures on the option chain had been different and the March 30 ask had been $4.25. The spread could have been instituted.
Sell two March 35 call contracts at $2.05 bid = $4.10 credit
Buy one March 30 call contract at hypothetical price of $4.25 = $4.25 debit
Total = $0.15 debit, to be added to the original $2.41 paid on January 12 for a new total debit of $2.56
The original breakeven would have been $37.41 plus commissions. (XEC must have closed at March expiration $2.41 above the $35 strike before the original position began making money.) In this hypothetical bull call spread, an extra $0.15 would have been added to the original cost paid, but the new breakeven would lower to $32.56. Because the trader is now long a March 30 rather than a March 35 call, XEC must close $2.56 above the $30 strike before the position begins making money.
XEC has a much better chance of closing above $32.56 than $37.41, pointing to a prime advantage of employing this strategy. Risk, in this case the price paid for options, increased by only $0.15 in this hypothetical case. No wonder McMillan suggests this tactic for consideration when a losing position needs repair and the spread can be instituted for no or little additional cost other than commissions.
What's the drawback? First, traders must have margin accounts and permission to sell options to create the spread. In addition, although the breakeven level has been successfully lowered, future gains are capped. The trader employing this strategy with these hypothetical prices can never profit more than $2.44, no matter how much XEC might gain.
To see how this works, imagine that XEC closes at $40.00 at expiration. Here's how the results stack up:
Long March 30 call is worth $10.00 = $10.00 credit
Sold March 35 call is worth $5.00 = $5.00 debit
Original January 12 call purchase = $2.41 debit
Extra cost to establish spread = $0.15 debit.
Total credit of $10.00 - total debit of $7.56 = net credit of $2.44
Now imagine that XEC closes at $35.00 at expiration. Same $2.44 net profit. The sold $35.00 call expires worthless, your long $30.00 call is worth $5.00, and your net profit is that $5.00 minus the total $2.56 you paid for options.
The drawback of that cap on gains balances the benefit of lowered breakeven level at no addition price. Of course, this position offers no addition protection if XEC were to continue diving. If XEC were to close below $32.56 at expiration, some or all the investment is lost. The tactic still seems worth investigation when McMillan's parameters are met, but perhaps not when the original loss was only 15 percent.
Options pricing realities did not make this rolling-down choice available. The calculations were based on a hypothetical price for the March 30 call that did not exist. It is important to examine why McMillan imposes the condition that the spread must be established for little or no extra cost.
As of the January 26 close, establishing the spread would actually have required a $2.30 debit in addition to the $2.41 paid for your original position.
Selling two March 35 calls = 2 X $2.05 bid = $4.10 credit
Buying one March 30 call = $6.40 debit
Total debit to establish spread = $2.30
Original call position established January 12 = $2.41 debit
Net debit = $2.30 + 2.41 = $4.71
Although McMillan allows that the spread might be established with a small debit, the total $4.76 cost would have been too high. That would have been only $0.29 below the $5.00 spread between the long March 30 position and short March 35 position. Imagine again that XEC closed at $40.00 at March expiration.
Long March 30 call worth $10.00 credit
Short March 35 call worth $5.00 debit
Total cost of options = $4.71 debit
Net profit = $0.29
With commissions subtracted from that maximum $0.29 profit, not much opportunity for profit existed using this strategy. In many other cases, the position can be established using McMillan's parameters and offering more possibility for profit from what was originally a losing position.
McMillan offers another strategy to repair a losing position. This one involves creating a spread, too, a calendar spread. In a calendar spread, a near-term call is sold against an intermediate- or long-term call of the same strike. Establishing this spread would have required selling a February 35 call against the original long March 35 call position. The option chain above suggests that the February 35 call could have been sold at a bid of $1.50.
Sell February 35 call = $1.50 credit
January 12 purchase of long March 30 call = $2.41 debit
Net debit = $0.91
Net debit was reduced to $0.91. A trader might consider this tactic if XEC might be likely to linger at or below the $35.00 strike level into February expiration but then climb into the March option expiration cycle. If XEC were to close at February expiration below $35.00, the sold call would expire worthless. The $1.50 credit would be retained, and the trader would still own a long March 35 call, with the total cost now reduced to $0.91. Breakeven would again be reduced with this tactic, but not by as impressive amount. In this case, breakeven would be a close above $35.91 at March expiration ($35.00 strike plus $0.91 net debit) as long as XEC closed below $35.00 at February expiration.
Even if XEC closed the March expiration period below $35.00, costs were reduced and so losses were, too. However, this tactic proves riskier than the previous one. What if XEC closes above $35.00 at February expiration? If XEC expired below $36.50 at February expiration, the call seller would still retain some or all of the $1.50 credit received for the sale of the February 35 call, but there's a worse case scenario to imagine.
Imagine that XEC were to immediately spring higher. For example, if XEC had bounced to $38.00 by February 2, a week after its acquisition announcement on January 26, the CBOE options calculator suggests that the February 35 call might have been worth $3.13 while the March one would possibly have been worth $3.61. (This did not happen. As of Thursday, February 10, XEC closed at $36.31.)
Only $1.50 was collected on the sale of the February 35 call, so you're under water by $1.63 on that position.
Hypothetical value of sold February 25 call on February 2 if XEC at $38.00 = $3.13 debit to call seller
Value collected on sale of February 25 call on January 26 = $1.50 credit
Net debit to the seller of the February 25 call = $1.63 debit
You originally paid $2.41 for your March 35 call, so you're up by $1.20 on that.
January 26 cost of March 25 call = $2.41 debit
Hypothetical Feb 2 value of March 25 call if XEC at $38.00 = $3.61 credit
Net credit = $1.20
The spread now shows a loss of $0.43.
Net debit on sale of February 35 call = $1.63 debit
Net profit on March 35 call = $1.20 credit
Net debit on spread = $0.43 debit
Remember that the benchmarked loss on January 26, when XEC gapped lower, was only $0.36 or 15 percent. In this hypothetical scenario in which XEC had climbed to $38 by February 2, a scenario that did not unfold, the original loss was smaller than that incurred by creating a calendar spread.
This proves McMillan's axiom that a calendar spread should be avoided in instances when a quick bounce is expected. McMillan also mentioned the deleterious effect on call spreads when volatility expands, so this strategy would not work well at a time when volatility might be expected to expand, either.
The put buyer in a losing position can employ similar strategies, a rolling-up strategy that involves selling two of the owned put and buying one higher strike put, creating a bear spread, or selling a near-term put against long intermediate- or long-term long put position, creating a calendar spread. The bear put spread strategy may be easier to employ than the bull call spread one was due to some peculiarities in options pricing. Puts tend to hold their value better when a stock moves up than calls do when a stock moves down. It may be easier to find cases when it's possible to sell two of the owned put for an amount equal to the cost of a single higher strike put.
McMillan cautions that anyone considering these repair strategies understands exchange and brokerage margin rules to avoid incurring margin calls or restrictions against trading. If considering such strategies, traders should familiarize themselves with the strengths and shortcomings of each, too. Run through some numbers. Set up paper trades. Know when you'll close a spread if it moves against you. In what cases would it have been better to take the loss immediately? Averaging down is rarely a good idea, but when would establishing a bull or bear spread have worked? What about a calendar spread?
The good news is that if you had been that hapless holder of a March 35 call when XEC announced that acquisition on January 26, you would have had more choices than you might have expected. The bad is that you have homework to do if you're to fully understand how you might employ these strategies. This article wasn't meant to be a comprehensive review of all risks and benefits, but rather an introduction to the possibility of employing strategies to repair losing plays. Pull out your McMillan for reference, call up the CBOE options price calculator on your computer, and go to it.
Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.
Option Investor Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.
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