Caterpillar Inc. (NYSE:CAT) stock has been resilient against many obstacle headlines. It has benefited from the Donald Trump rally, but I bet it would have done just as well without it. CAT is now 43% higher than 12 months ago. This cannot all be from the hopes that fiscal spending will get done this year. Buying of this size in a mature stock usually is based on strong fundamentals.
CAT reported earnings this morning, and they indeed delivered great results. So the fundamental story is still alive and well so bulls still have the upper hand. The trend will continue until we get a market-wide drop, and that is not an evident forecast. Strong upside momentum continues upwards for as long as the macro is also moving higher especially with strong fundamentals like CAT’s.
Click to Enlarge So did I miss the trade? No. Thanks to CAT options, I can still profit from the price action as if I had a time machine.
Key to my success using options to trade Caterpillar stock is that I am willing to sell risk for income below support levels. I cannot do this in stocks if I don’t believe in their fundamentals. CAT has value even at these levels and with today’s news.
Furthermore, the promise of fiscal spending is a thesis that is not likely to die soon. I believe that politicians will kick the can long enough to keep the promise of infrastructure spending lingering for a while. This will keep a bid below CAT. The bulls are then likely to buy any dips we may get.
Fundamentally, CAT stock is not cheap, but luckily the analysts are not expecting much. Most of them rate Caterpillar as a hold, which reduces the likelihood of a deluge of downgrade headlines. In fact, we could have a few upgrades to come.
Since January of 2016, Caterpillar stock has been jumping from one breakout pattern to another thereby feeding this amazing 85% rally. So for this to change, the story of CAT needs to change in a material way and I don’t believe that management did that today.
So for as long as the story remains the same, I sell risk into CAT stock options to generate income. Prerequisite to my strategy is that I am willing to own the shares should I be wrong. This is a method that serves me well in a bullish equity market as evidenced by this recent win.
CAT Stock Trade Idea
The Bet: Sell CAT Jan 2018 $87.50 puts to open and collect $1.75. This is a bullish trade where I have 90% theoretical odds that price to stay above my strike so I can retain max gains. Otherwise, I have to own the shares and could suffer losses below $85.75.
I am comfortable owning the share since I built a 20% buffer from current price. I am confident that I can manage out of my position with no lasting damage. This is an important element in my trading style. For a safer alternate method I could sell spreads instead of naked puts.
When I sell a spread I limit my risk by buying equal number of puts as those I sell, thereby limiting the worst case scenario. The margin requirement then becomes a finite amount equal to the width of the spread less what I collect to open.
The Alternate Bet: Sell the CAT Jan $87.50/$85 bull put spread where I have about the same odds of winning. The spread still offers an attractive 25% yield. Compare this with needing to go long CAT in the open market, where I’d have to risk $113 at face value then hope it rallies 25% more so I can profit without any room for error.
Investing is risky business — otherwise we’d have no reward. But I never risk more than I can afford to lose.
Learn options as easy as 1-2-3 here. 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.
