The last 12 months have been kind to Caterpillar Inc. (NYSE:CAT) investors. The stock enjoyed a 50% rally from the Feb 2016 lows. Behind solid fundamentals, investors piled into the stock especially after the election. The Donald Trump promises played perfectly into CAT’s prospects. Federal spending means infrastructure projects which should translate into more demand on CAT products and services.
So the perfect scenario is set and therein lies the problem. From perfection, any change would result in a worse outcome. So consider today’s trade a bearish bet against the Caterpillar stock price action and not the company.
In fact, I will leverage the intrinsic value of the company to finance my bet. The end result is a free chance at profits.
Technically, CAT stock fulfilled almost every technical set-up perfectly. The bad news is that of late, price has been bouncing on a floorboard which has been holding so far. But if the floor breaks, bears tend to overshoot into the basement. In that scenario, CAT could fill the giant November gap and retest the $86-per-share area.
CAT Stock Trade Idea
Click to Enlarge The Bet: Buy the CAT Apr $87.50 put for $1.20 per contract. This is my maximum potential risk. I need CAT to fall through my position before mid-April to profit.
This trade also is a proxy short to equity markets in general, so a market correction would greatly improve my chances of profit.
Earlier I noted that the trade will be free. Since I believe in the CAT fundamentals, I am comfortable selling downside risk against levels I deem safe.
The Bank (Optional): Sell the CAT Aug $75 put and collect $1.40 per contract. By doing this I commit to buying CAT shares at $75 if price falls below my put sold.
By taking both trades I would essentially be getting paid to be short CAT for the next 38 days. As long as Caterpillar stock stays above my sold risk, any premium I recapture from selling back my debit puts would be pure profit.
Trading naked puts can be dangerous and I only do it if I am willing and able to own Caterpillar stock at that price. For less risk, I can modify either of these trades into a spreads instead. Then I would have finite risk profiles. The concept stays the same — leverage the long-term CAT value to profit from the short-term price action.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @racernic and stocktwits at @racernic.
