Trade CAT with options, here's how

Playing the “Dead CAT Bounce”

Caterpillar Tractor (CAT | Quote | Chart | News | PowerRating) got slammed today following guidance from the company that future earnings would be down from current levels, despite beating estimates for Q3. The company lowered its financial outlook for 2005 and 2006. The stock price dropped $2.78 (5.2%) to $51.25, in pre-market action, and opened even lower on the NYSE at 49.26, as seen in Figure 1.

Figure 1 – Generated by OptionVue 5 Options Analysis Software

With uncertainty surrounding future earnings, this is a nice setup for a call credit spread, as presented in previous articles. Figure 2 presents the profit/loss plots for interim time frames and at expiration (solid line) for a January 55 x January 60 call spread. The spread collects approximately $60 with a margin required of $440, and has a breakeven point 11.6% above the level of CAT at the time these prices were taken. Breakeven is at 55.60 (not calculating commissions).

Figure 2 – Generated by OptionVue 5 Options Analysis Software

Another way to play this is to wait for a so-called “dead-cat bounce,” a post gap bounce that often occurs before renewed selling sets in. That would give you a slightly better entry point. In any case, apply the stop loss used in previous trades. Close the spread if it doubles, or if the price rallies back to the “not likely to go zone”, the pre-gap price area of 54.

Good luck with your trades.

Cheers!

John Summa

John F. Summa is Founder and President of OptionsNerd.com, and a registered Commodity Trading Advisor (CTA) with the National Futures Association (NFA). Founded in 1998, OptionsNerd.com offers trading seminars and tutorials to options traders, futures and option trading advisories and managed futures and options CTA account services. Mr Summa's trading articles have appeared in Technical Analysis of Stocks & Commodities magazine, as well as Active Trader Magazine, Options Trader Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com. He coauthored Options on Futures: New Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking book, Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets (John Wiley & Sons, 2004), which includes Mr. Summa's innovative quantitative bear and bull news-flow Contrarian indicator. Mr. Summa is a PhD-trained economist and operates a delta-neutral options trading CTA program.

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