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Emerging options in play: CAT

|Includes:Caterpillar Inc. (CAT), SPY

As the global market continues to push higher, some large-cap names are becoming interesting ideas for traders looking to add options to a standard long-only portfolio. Looking at the VIX, we are seeing continued pressure on volatility as this volatility-driven index seems to have found a range between 20 and 25 -- well off the nosebleed-inducing 45 it touched during the May euro crisis.

The 200-day moving average currently 23.5 and is trending sideways, which according to the bodes well for a market that could hold this range and continue its current uptrend. This, in turn, makes stocks like Caterpillar CAT interesting, 



Caterpillar: in position

CAT is a stock that looks well positioned to take advantage of domestic infrastructure initiatives and continued booming construction in places like Brazil. Given bullish momentum for the S&P 500 SPY as a whole, this a solid industrial stock that appears to be well positioned for further upside -- and more than half of its revenue already comes from overseas, so it is highly leveraged to emerging markets growth.

The stock is currently trading at around $78.15. If you think the stock can move higher, you can buy 100 shares at $78.15 and also sell the January $85 option (currently priced at $2.38) that obligates you to sell 100 shares at $85 in January. If you buy 100 shares at $78.15 apiece and sell 1 January 85 call for $2.38 you can potentially realize a gain of 11.8%. Writing the January 85 call allows you to collect 3% premium on the stock. If the stock trades between 78.15 and 85 at January expiration you will collect the 3% premium on the option write, plus the accumulated value of the stock. Your breakeven on the spread is 82.62.

If CAT rises, but remains below $85, your option entitles you to sell your shares that above-market price, netting a return of 8.7%. Add the $2.38 a share you got for your option, and your total return could come to 11.8%. If CAT rises above $48, you forfeit the extra appreciation, so your total return is capped at "only" 8.7%. However, the covered call should add to your performance as long as CAT stays under $82.62. And if CAT declines, the $2.38 a share you got in cash when you wrote your sell option helps to minimize the downside.  

Disclosure: no position

Stocks: CAT, SPY