Shares of construction stock Toll Brothers (NYSE:TOL) broke out to the upside yesterday as construction stocks continue to head higher. TOL stock made a new recent high and broke past the $39 resistance level. Toll Brothers stock now sits at the highest price since June 2018.
TOL stock also saw unusual call buying with the highest option volume of the year. Whether or not the breakout will be bonafide remains to be seen, especially given that TOL has been up five days in a row. Time to take a guardedly bullish stance in TOL stock.
Toll Brothers stock is still cheap on both a comparative and absolute basis. The current P/E sits at just 9.9, roughly half of the five-year average 17.1. It is also well below the 19.5 P/E ratio for the S&P 500.
Other valuation metrics, such as price/sales, price/book and price/cash flow, are at similarly attractive levels. Price/sales is hovering just above the cheapest levels of the past ten years. TOL stock is looking like a relative bargain even after the recent rally.
TOL stock, however, has become extremely overbought on many technical levels. Nine -day RSI is well over 80 and at the highest reading of the past year. Previous instances when nine-day RSI breached 80 proved to mark significant intermediate term tops in Toll Brothers stock.
MACD is fast-nearing an extreme as well. Bollinger Percent B just blew past 1, yet another sign that buying may be getting out of hand. TOL stock is now trading at by far the biggest premium to the 20-day moving average over the past year. Prior premiums of this magnitude were invariably met with a pullback.
Most importantly, TOL stock pulled back well off the intra-day highs yesterday. Shares traded all the way up to new yearly high at $41.70 only to reverse and close down nearly $1.00 from those highs at $40.76. This type of reversal pattern is many times emblematic of a short-term top.
Buyers have become exhausted and the sellers are in control. It is even more powerful given the magnitude of the previous rally and since TOL stock failed to hold on to yearly highs.
The options market, though, seems to feel the rally will continue. Yesterday saw enormous unusual call volume in the October $41 calls. Over 24,000 contracts traded compared to just 11 contracts of open interest. The 24,000 contracts could potentially equate to a buy of 2.4 million shares of TOL stock. This big buyer also lifted implied volatility from 24.50 to nearly 30, meaning option prices became much more expensive.
This sets up ideally for a covered call trade in Toll Brothers stock. One can follow along with the big call buyer in a bullish manner by going long 100 TOL stock to play the breakout and attractive valuations. At the same time, one could give credence to the overbought technicals by reducing risk and capturing rich option premium by selling the October $41 calls. The overall cost for the trade would be around $39.40 based on the closing prices.
The covered call trade would be 51 deltas net long — or the equivalent of 51 shares of Toll Brothers stock. Essentially the trade cuts the risk in half while still allowing for decent upside.
Ideally TOL stock closed above $41 at October expiration to realize the maximum profit of $1.60 or approximately 4% in 32 days. If Toll Brothers stock closes below $41 addtional call options can be sold against the stock to further reduce the risk and bring in more premium.
Tim may hold some of the aforementioned securities in one or more of his newsletters. Anyone interested in finding out more about Tim and his option-based strategies can go to https://marketfy.com/item/options-and-volatility.