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The strategy we are going to look at today has two components to it. In the first part, we sell a put. In the second part, the proceeds from the sale of the put are used to leverage your position in Caterpillar Inc. (NYSE:CAT). One of the best times to utilize this strategy is after a strong stock has pulled back nicely and is in the process of putting in a bottom formation. Caterpillar fulfills these requirements almost perfectly.

If you look at a 1 year chart (illustrated further in the article) you will see that the stock is trading well off its highs and is now in the process of completing a bottom formation. It is worth nothing that the stock also appears to have just completed a double bottom formation.

The benefits of this strategy are twofold. If the stock should take off while you are waiting for the shares to be put to your account, the calls you purchased will protect you from missing out on any gains. On the other hand, if the stock pulls back you have the chance to get in at a price of your choosing.

Benefits associated with selling puts

  1. In essence, you get paid for entering a "limit order" for a stock or stocks you would not mind owning.
  2. It allows one to generate income in a neutral or rising market.
  3. When you sell a naked put you are in a way acting like an insurance agent. The Seller of the option agrees to buy the stock in the future if it drops to a certain level before the option expires. For this, you (the seller) are paid a premium upfront. If this strategy is repeated over and over again these premiums can really help boost your returns over time.
  4. Acquiring stocks via short puts is a widely used strategy by many retail traders and is considered to be one of the most conservative option strategies. This strategy is very similar to the covered call strategy.
  5. The safest option is to make sure the put is "cash secured." This simply means that you have enough cash in the account to purchase that specific stock if it trades below the strike price. Your final price would be a tad bit lower when you add the premium you were paid up front into the equation. For example, if you sold a put on a stock with a strike at 20 for $2.50, and the shares were put to your account. Your final price per share would be $17.50 after the premium was factored in.
  6. Every day you profit via time decay as long as the stock price does not drop significantly. In the event it does drop below the strike you sold the put at - you get to buy a stock you like at the price you wanted. Time decay is the greatest in the front month.

Some reasons to be bullish on Caterpillar:

  1. A very healthy quarterly earnings growth rate of 48.9%
  2. A levered free cash flow of $2.65 billion
  3. A five year dividend growth rate of 7%.
  4. A 3-5 year projected EPS growth rate of 11.8%
  5. A very low payout ratio of 19%. This means the company has plenty of room to easily increase its dividends for years to come.
  6. A strong interest rate coverage of 8.52
  7. Annual EPS before NRI increased from $5.37 in 2007 to $7.81 in 2011.
  8. The company's focus on expanding by opening up new facilities in emerging markets will help provide new streams of future revenue and growth.
  9. It still has a substantial backlog of roughly $23 billion.
  10. The merger with Bucyrus has made it the leading mining original equipment manufacturer on the globe. This acquisition has helped Caterpillar gain a firm foothold in strong mining markets such as China and India. Caterpillar is also in the perfect position to leverage Bucyrus' thriving aftermarket parts business while providing supporting services for its own equipment.

The technical outlook

(click to enlarge)

Source = marketbrowser.com

It tested the $79.00-$80.00 ranges on the 18th of November, a zone of strong support and managed to hold above this level. In testing this zone it also appears to have completed a double bottom formation. Both these developments are bullish and suggest that the stock is close to putting in a bottom. As the markets are still rather volatile, there is a good chance that it could test its July lows at $78.25 on an intra day basis. We would wait for a test of the $80.00 ranges before putting this strategy to use.

There is quite a bit of resistance in the $87.50-$88.00 ranges and a weekly close above this zone will be a very bullish development, and it should result in a test of the $95.00-$97.00 ranges. On the other hand, a weekly close below $78.25 could result in a test of its two year lows ($68.00-$69.00). The support at this level is much stronger and if it were to test this zone, we would view it as an excellent long-term entry point.

How does the competition stack up?

It has much higher operating margins than its competition and its operating margin of 0.14 is 50% higher than the industry average of 0.07. It also has a strong quarterly earnings growth rate of almost 49% and a healthy 5 years EPS growth rate of 10%.

CAT

(NYSE:CNH)

(OTCPK:KMTUY)

(OTCPK:VOLVY)

Industry

Quarterly revenue growth

0.05

0.04

-0.06

-0.06

0.08

Revenue

67.04B

20.30B

24.48B

47.79B

1.05B

Gross Margin

0.27

0.24

0.27

0.24

0.28

EBITDA

12.10B

2.83B

4.17B

4.19B

68.66M

Operating Margin

0.14

0.12

0.12

0.07

0.07

Net Income

6.53B

1.14B

1.76B

2.25B

N/A

EPS

9.76

4.73

1.84

1.11

N/A

P/E

8.61

9.88

12.02

12.55

15.70

PEG (5 yr expected):

0.65

1.19

-3.66

1.37

0.99

P/S

0.82

0.55

0.86

0.59

1.09

M= Million B= Billion

Charts and Tables of interest and value

(click to enlarge)

The blue shaded area represents the dividends. The orange line represents the valuation growth rate line. Generally, when the stock is trading below this line and in the shaded green area, it represents a good long-term entry point. The stock is currently trading below this line which means that the current pullback could prove to be a long term buying opportunity.

Zacks put the risk level as below average for this stock. EPS for 2012 is projected to come in at $8.91, a year over year increase of 12%. EPS is expected to pull back a bit in 2013 to $8.77, due to a decline in worldwide economic activity. However, these figures could be raised if emerging nations show stronger signs of growth.

The Strategy

Part 1

(click to enlarge)

The Feb 2013, 80 puts are trading in the $2.86-$2.91 ranges. If the stock pulled back to the stated ranges these puts should trade in the $4.40-$4.60 ranges. We will assume that the puts can be sold at $4.50 or better.

Part 2

(click to enlarge)

The Feb 2013, 87.50 calls are trading in the $2.08-$2.13 ranges. If the stock pulls back to $80 or better, these options should trade in the $1.35-$1.50 ranges. We will assume that the calls can be purchased at $1.50 or better. For each put sold, you will be in a position to purchase up to 3 calls. In this example we will aim for two calls. The balance of $1.50 will provide us with additional downside protection and lower our breakeven point from $80 to $78.50. If the shares are put to our account at $80.00, the position would only show a loss if the stock dipped below $78.50.

Transaction details

  1. For every put you sell you will be in a position to purchase up to three calls. In this example, we will only be looking to purchase two calls.
  2. Total monetary requirement for this strategy is $7850 ($8000 minus the remaining credit of $150 that was left over after we sold one put and purchased two calls)
  3. Your maximum risk per put sold is $7850.
  4. Your profit potential is unlimited as a result of the call that was purchased.

(click to enlarge)

Benefits and risks associated with this strategy

  1. As an investor you have an opportunity to significantly leverage your position in this stock for a relatively low fee.
  2. If the stock should take off, you have the opportunity to benefit from this upward move via the calls you purchased.
  3. You have the opportunity to get into this stock at a lower price If the stock trades below the strike price, you sold the puts at, the shares could be assigned to your account (assignment usually occurs on the last trading day of the option). Depending on the number of calls you purchased your cost per share could range from $77.00 (if you purchased one call only) to $80.00 (if you purchased three calls).
  4. As long as you are bullish on the stock, having the shares assigned to your account should not be an issue. If you do happen to change your mind and feel that the stock could trade well below the strike price you sold the puts at, you can simply roll the put. Buy back the old puts and sell new out of the money puts.

Suggested strategy to lower your risk

You could purchase a put with less time on it to hedge your position. It would be a variation of the bull put spread. Instead of purchasing and selling puts with the same amount of time on them. For example, you could purchase a put that expires in January and sell a put with an expiration in February. For example, you could purchase the Jan 2013, 77.50 put. This strategy would limit your downside risk until Jan.

Conclusion

This strategy provides investors with the means to establish a long position without having to purchase any stock. This strategy should not be abused because the shares could be put to your account if the stock trades below the strike price you sold the puts. As long as you are bullish on the outlook of this stock, this should not be an issue. If you have a change of heart and feel that the stock could trade much lower, you could simply roll the put. Wait for the stock to test the $80 ranges before putting this strategy to use. Consider closing the position out if it is showing gains in the 65%-100% ranges.

Options tables sourced from yahoofinance.com. Option Profit loss graph sourced from poweropt.com. Competitor comparison data sourced from yahoofinance.com . Zack's consensus estimates sourced from zacks.com.

Disclaimer

It is imperative that you do your due diligence and then determine if the above strategy meets with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.

Source: Time To Buy Caterpillar With This Low-Risk, High-Reward Strategy