We could babble about Jackson Hole, the eurozone, the failure of our political leadership, the death of the dollar, gloom and doom, ad infinitum et nauseum. Instead, we're babbling about trading.
We had been long TLT since February, but we've taken profits and now we're not. Instead we now like the stock market, however fleetingly. Specifically, we like the steel, transport, oil service and airline sectors. These are the least loved sectors, the ones loved least the longest. Within those sectors we like companies that have fallen the farthest the fastest.
In steel, we like AK Steel (AKS) and here's why:
Multiple insider buying in August. Insider buying is one of our most reliable leading indicators. During the month of August, seven different officers and directors including the CEO purchased $550,000 of the company stock between 7.77 and 8.09.
Reversion to the mean. AKS has lost over half its value in less than two months. It has definitely under performed, but with a rebound in the general market in the offing, the next direction may well be up.
Short squeeze candidate. As of August 15, the short interest in AKS again increased, this time to over 20% of the float.
Depressed sector with positive seasonal characteristics. It's no secret that steel is perhaps the least loved sector on the planet. At the same time, with the general market about to rebound strongly, the seasonal characteristics of industrial stocks should sweep AKS along with the tide.
We did this trade on August 26:
Bought AKS stock at 8.05 with one third of the position; sold AKS September 7.50 puts at 0.35 with one third of the position; and sold AKS October 9.00 puts at 1.50 with one third of the position.
We structured the trade this way as a defensive mechanism. It allows us to participate in the potential upside and cushions us against the downside. We are defensive contrarian traders by nature; and we are proponents of the maxim it's not what you make, it's what you keep. With that in mind, here is how this trade could work out.
- AKS trades sideways between 7.50 and 9.00 through September and October. The September put options expire worthless and the stock from the 9.00 October puts is assigned to us. Our average entry price for two thirds of a position in the stock would be 7.60 [(8.05 - .35) + (9.00 – 1.50) / 2 = 7.60].
- AKS trades below 7.50 through September and October. The stock from both put trades is assigned and our average entry price for a full position in AKS stock would be about 7.57 [8.05 + (7.50 - .35) + (9.00 – 1.50) / 3 = 7.57].
- AKS trades above 7.50 by mid-September and then above 9.00 by mid-October wherein all options expire worthless, leaving us with one third of a stock position in AKS at an entry price of 6.20 [8.05 - (.35 + 1.50) = 6.20].
While the September put options being assigned and the October options then expiring is a possibility, we view it as somewhat remote. However, for the purists among us, if that happened our overall entry price on two thirds of a position in AKS stock would be 6.85; interestingly, this would likely then be the best outcome.
Relatively elevated levels of implied volatility in the options make this trade viable. While we would like a little more downside protection, both the general market and the recent price action have already taken their toll on AKS. Next chart support is at about 6.25 and with the reasonably short fuse to option expiration we should know fairly quickly whether we will hold 'em or fold 'em.
Although we do not use profit targets or objectives per se, we observe the chart resistance in the 12.50-14.00 range; and this would be a likely area for profit taking since we view the coming rally as a temporary counter-trend move.
Disclosure: I am long AKS.