We wrote an article on Arch Coal (ACI) on the 19th of June stating that investors should consider selling the Jan 2014, 5 puts. The goal was to either get in at $3.50 or walk away with a gain of 30%. Those who followed this advice are sitting on gains as the puts have already lost roughly 26% of their value. In fact, on the 14th of September, the stock traded as high as $8.05 before pulling back. At that point, the stock was trading over $2.35 above the suggested entry points, and the put at one point was over $3 out of the money. Today we are going to review and update our outlook on this play. Before we continue, we would like to list the reasons we provided as to why investors should consider this play. The stock and the sector in general are not viewed in a positive light, and that view still applies today. Hence it was difficult to paint a bullish picture on a sector that was so beaten down and generally disliked by the public.
Reasons to be bullish on Arch Coal Inc:
- Strong institution support: Percentage held by Institutions = 79%
- Net income is trending upwards for the past three years. Even though it dropped in 2011 it is still almost over 100 million higher than it was back in 2009. In 2009, it stood at $42 million in contrast to $142 in million in 2011.
- EBITDA has increased from $450 million in 2009 to $824 million in 2011.
- Cash flow has increased from $2.41 in 2009 to $3.14 in 2011
- A decent quarterly earnings growth rate of 19%
- An operating margin of 9.44%
- A yield of 2.00%
- Percentage short of float is an astounding 24.3%, making it a perfect candidate for a short squeeze.
- A good current ratio of 1.55
- A free cash flow yield of 5.05%
- A 3-5 year projected EPS growth of 11.8%
- A five-year sales growth of 11%
Let's take a look at the trade
We offered the following advice in that article:
It is trying to put in a bottom in the 5.60-6.00 ranges. A stock usually tests its recent lows and ends the week on a higher note as a sign that a tradable bottom is in place. Investors should consider waiting for a re test of the 5.60-5.80 ranges before jumping in
The stock pulled back as expected and traded within the suggested ranges on the 26th of June. It traded as low as $5.41 and finished the day at $5.55. It went on to trade to and below these suggested entry points, twice more as indicated in the chart below.
Investors were provided with three opportunities to put this strategy into play (as indicated by the brown boxes in the chart above). On the 26th of July, it traded as low as $5.16 but finished the day off its lows at $5.26. Five days later it traded as high as $7.76, which represents a gain of over 50% from its July 26th lows. The stock went to trade as high as $8.05 on the 14th of September and is currently trading 17% above the original suggested entry points.
In that article we suggested implementing the following strategy
The Jan 2014, 5 puts are trading in the 1.29-1.34 ranges. If the stock trades down to the suggested ranges, these puts should rise in value by roughly 25 cents. For this example, we will assume that the puts can be sold for 1.50. For each contract sold $150 will be deposited in your account.
The stock had to trade to the $5.60-$5.80 ranges before the strategy could be put into play. As the stock went on to trade well below our suggested entry points, and we used a very conservative price for the puts, investors should have easily managed to sell the Jan 2014, 5 puts for $1.50 or higher. The stock closed at $6.19 on the day the article was written, 56 cents above the lowest suggested entry point. This stock has a high beta of 2.17, and the option had and still has plenty of time on it, so the puts should have easily managed to tack on an extra 16-21 cents.
Technical outlook going forward
The stock is currently consolidating, and building momentum to trade past the 8.00 ranges. It is has tested the $7.90-$8.00 ranges several times over the past four months, and each time it has failed to break through. The stock is currently establishing a nice long channel formation and has been putting in a bullish formation of higher lows since the 26th of July. Generally, when the stock trends sideways after a strong correction and puts in a pattern of higher lows, it usually signals higher prices. The percentage short of float is 32%. This is a very high number and this makes Arch Coal a perfect candidate for a short squeeze. We have already seen how fast the stock can move. It tacked on 50% within 5 days from its July 26th low of $5.16 to its high of $7.76 on the 1st of August.
The stock also managed to test the $8.00 ranges for the first time in 4th months consecutively on the 14th and 17th of September. Even though the stock subsequently pulled back, we believe that this move past the $7.90 ranges is a precursor for a much stronger move. A weekly close above $8.00 should set the stage for test of the $10.50-$11.50 ranges. Another factor to keep in mind is that the stock is trading almost $8.00 below book.
Arch Coal versus the competition
We are going to use key ratios such as quarterly revenue growth, revenue, EBITDA, etc. to see how it holds up against competitors such as Alpha Natural Resources (ANR), Peabody Energy Corp (BTU) and Consol Energy Inc (NYSE:CNX).
A look at what the puts are doing right now
The puts are currently trading in the $1.06-$1.13 ranges. They have lost 26% of their value in roughly two months. If they were closed out today, you would walk away with a gain of 8%, which is a pretty good rate of return in this low-rate environment. This is in line with what high-yield dividend stocks such as Linn Energy (LINE) and SeaDrill (NYSE:SDRL) pay on annual basis. They offer yields of 7.00% and 8.6% respectively. The only difference being that these gains were achieved over a period of two months. We are not advocating that you close the puts out now as we feel that the stock could trade significantly higher and that the puts could be practically worthless once the stock trades past the $10 mark.
Suggested strategy going forward
The stock is consolidating and building up momentum to trade past the $8.00 ranges. Once it manages to close above $8.00 on a weekly basis, the outlook will turn very bullish and the stock should have no problem testing the $10.50-$11.50 ranges at this point. It could trade as high as $13 before experiencing a strong correction. We would close the entire position out the moment it trades within the $10.50-$11.50 ranges. As the puts will be over $5.50 out of the money, they should be practically worthless.
Suggested strategy to boost your returns
Individuals seeking higher returns could use some of the premium they received from the sale of the puts towards the purchase of calls. For example, you could purchase the April 2013, 8 calls which are currently trading in the $0.84-$0.87 ranges. If the stock trades to the suggested targets, these options should be showing gains in excess of 100%.
The options have already lost roughly 26% of their value and if the positions were closed out today, you would be walking away with a gain of roughly 8% in little over two months. This is not a bad rate of return considering that this the equivalent of what some high yielding divided stocks pay today.
The percentage short of float stands at a very high 32%, making it a great candidate for a short squeeze. This stock has a high beta and can move very fast so any positive news could really have a big impact on the price of the stock. This sector is still generally viewed in a negative light so from a contrarian perspective it still makes for a good long term play. Finally, the stock is trading roughly $8.00 below book value. If the stock trades to the $10.50-$11.50 ranges, investors should consider closing the position out.
Option tables and competitor's data sourced from yahoofinance.com.
It is imperative that you do your due diligence and then determine if the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was prepared for Tactical Investor by one of our analysts. We have not received any compensation for expressing the recommendations in this article. We have no business relationships with any of the companies mentioned in this article.