A Range-Bound Play On Caterpillar

| About: Caterpillar Inc. (CAT)
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Since 2011, we've seen Caterpillar (NYSE:CAT) display more volatility than we may be used to. After bouncing from around $120 per share to $75 a few times, Caterpillar has traded in a very narrow range for most of 2012. Range trading is nothing new to most shareholders, and it's usually acceptable price action when there's a dividend -- which Caterpillar has, yielding 2.4% -- until the stock finally breaks out of its funk. Well, I'm here to profit on Caterpillar, but on the range trading rather than the breakout.

Click to enlarge images.

Source: Stockcharts.com.

A look at the chart above will illustrate just the type of range trading I mentioned above. Since May, when Caterpillar fell from $100 down to $82.50, it has been stuck primarily within a $5 range. It has endured six months of trading in the range of $82.50 to $87.50, with a few occasional dips or pops outside of the range. I plan to use options to take advantage of this relatively longer-term sideways action.

The Trade

  • Sell 1 87.50 January Call at 1.90
  • Sell 1 82.50 January Put at 1.80
  • Net Credit (Max Gain): 3.70 ($370)
  • Max Risk: Unlimited
  • Break-even points: $91.20 and $78.80
  • Days Until Expiration: 43

I should first mention that if you're not comfortable or are completely new to options, this trade should most likely be done in a simulated account due to the higher risk nature created by the naked options. The essence of the trade is for Caterpillar to remain range-bound and stay between $87.50 and $82.50, or the two short strikes.

The break-even points represent how far the stock can move outside of the range before it is no longer profitable. If the stock reaches either $78.80 on the downside or $91.20 on the upside, it will no longer show any profit. The max gain on this trade is $370, or the premium collected.

This options play requires the investor to have strict risk disciplines, due to the options being naked. When an investor has an open naked options position, it exposes them to excessive risks. For many, this is isn't an option -- due to personal or margin-related issues -- and to counter the large risk put on by the naked options, we could simply "cap" them. To cap them, we'll need to do a spread, which would look something like this:

The Trade (Spreads)

  • Sell 1 87.50 January Call at 1.90
  • Sell 1 82.50 January Put at 1.80
  • Buy 1 90 January Call at 1.05
  • Buy 1 80 January Put at 1.15
  • Net Credit (Max Gain): 1.50 ($150)
  • Max Risk: 2.50 ($250)
  • Break-even points: $81 and $89
  • Days Until Expiration: 43

With the additional long contracts, we have effectively entered an iron condor, or two credit spreads, using calls for one spread and puts for another. By adding the two long calls, we cap our max loss to $250. The reason the max loss is not $500, is because the stock can't close above $90 and below $80 simultaneously.

The goal here remains the same as when the trade was put on using naked calls and puts: for the stock to close in between the short strike prices, or between $82.50 and $87.50. We chose the January expiration options because it is most advantageous to use options with only 30-45 days remaining until expiration. This will allow us to collect the most premium relative to the rapid time decay the options will soon be experiencing. A look below will illustrate how time decay affects options in the last few months before expiration:

Source: Optionalpha.com.

Fundamentally, I expect Caterpillar to remain stagnant over the next several months. Unless a significant catalyst presents itself, I believe Caterpillar will likely stay within the range that it has been in for the past six months. The closer and closer we get to January expiration, with Caterpillar still in between the short strikes, the more and more profit will show due to the amazing effects of time decay.

The break-even points could also be used as a stop-loss as well. At each of the break-even points, the trade will show a $0 gain, which is when investors could choose to exit the trade with no gain or loss (minus commission costs). With Caterpillar trading at $85.22 as of this writing, the short strikes are equally positioned apart -- ideal when putting on this type of trade.

Disclosure: I may initiate a (credit) options trade to take advantage of range-bound trading in CAT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.