After the U.S. 2016 elections, Caterpillar Inc. (NYSE:CAT) stock joined the general markets in the Donald Trump rally, and it did so in a fantastic way. This brings CAT stock’s 18-month rally to 57% upside. Such a rise, while it rewards current stakeholders, it presents challenges to those who want to get on board.
When stocks rally this fast, they perpetually seem on the verge of a correction. So potential investors wait, holding out for a dip that may never come. And often when there is a dip, then they are afraid to catch the proverbial falling knife.
In CAT’s case, the stock has headline challenges, including ongoing potential regulatory issues. Yet, it still powers ahead. Stocks that don’t fall on bad news have strong momentum behind which I can sell risk for income.
Click to Enlarge Largely responsible for the upside that investors are pricing into CAT stock is the promise of fiscal spending here and the ongoing global efforts to spruce up growth. This should translate into more demand on Caterpillar products and services. I realize that there is a potential pitfall inherent when Wall Street expects perfection, but the fiscal spending scenario cannot be debunked for months, and therein lies the opportunity.
Fundamentally, CAT stock is not the obvious choice from within the sector. But Wall Street is giving it a lot of credit, as its stock shrugs off bad news and maintains momentum that has kept it at highs for months. I give credit to management for its ability to spin the news. This dynamic is a trade-able phenomenon.
Technically Caterpillar stock is showing ongoing upside potential. But when a stock rises as fast as CAT stock has, it becomes vulnerable to dips. It may take a while for it to trip, but when it does, it would shake recent longs out quickly, thereby creating the impression of an abyss in price. So this raises the need to be surgical with risk placement. It’s just as hard to chase a shooting star as it is to catch a falling knife.
Today I want to generate income from selling risk below support levels that have held through adverse headlines. The prerequisite is that I am willing to temporarily own the shares should price go against me in the next few months. I see an opportunity area for my risk that is just above the halfway mark of CAT’s decade midpoint.
CAT Stock Trading Advice
The Bet: Sell Dec CAT $85 puts and collect $1.25 per contract to open. This is a bullish trade that needs the price to stay above my strike so I can retain max gains. I have a 90% theoretical odds for success. Otherwise, I must own the shares and would suffer losses if the stock falls below $83.75.
Selling naked puts carries big risk and therefore requires margin. I could mitigate the risk to accomplish the same strategy by using spreads instead.
The Alternate Bet: Sell the Dec CAT $85/$80 credit put spread, where I have about the same chances of success to yield 10% on risk. This is much more attractive to me than to risking $107 to buy CAT shares here and without any room for error then hoping that it to rally 10%.
There are no guarantees when investing in stocks, so I never risk more than I am willing to lose.
Learn how to generate income from options 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.
