If you want to see what a stock looks like as it is forming a head-and-shoulders pattern, Merck (NYSE:MRK) is a textbook example. The pattern has a neckline at $42, a left shoulder at $44, a head just under $48 and a right should that is forming at $44. If this pattern continues, as we anticipate it will, the stock will shortly be back down at the neckline at $42.
Click to EnlargeAfter soaring higher between early-June and mid-October, MRK appears to be losing some steam as investors grow increasingly concerned about the company’s potential profits moving forward. One of the most pressing concerns revolves around the fear that Congress and the President, in an attempt not to go over the Fiscal Cliff, may try to find spending cuts in Medicare by squeezing pharmaceutical companies on drug costs. This could smother MRK’s profit margins. Plus, if we do go over the Fiscal Cliff and tax rates on dividends go up, MRK’s strong dividend may not look quite as appealing as it once did.
With this in mind, we are buying the $42. The closer and closer the stock gets to this level, the more inflated the extrinsic value in our option will become, as the at-the-money strike price always has the largest amount of extrinsic value.
Recommendation: Buy to open the MRK Jan 42 Puts (MRK130119P00042000) for a maximum price of $0.40.
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