Options Play on Johnson Controls: Capture the Pullback With Less Risk

| About: Johnson Controls (JCI)

Looking at a 2011 price chart for Johnson Controls, Inc. (NYSE:JCI) could leave you scratching your head about where it’s headed. The channel-constrained trading is not event-driven as I mentioned in my recent Johnson Controls valuation article, where I dig deeper into the fundamental valuation, but simply an amplification of broad market movements.

Johnson Controls has three main lines of business: automotive interiors (51% of sales), building efficiency (35% of sales), and power solutions (14% of sales) which focuses on automotive batteries. Revenues are increasing, but not faster than what the market has priced in.

The latest outlook from Johnson Controls’ management expresses an extremely optimistic view of their power solutions market with skyrocketing demand for start-stop vehicles (as opposed to plug-in hybrids). If demand really does rise at this rate, their high margin solution will experience an onslaught of competition, forcing tighter margins and trimming total sales.

My valuation puts Johnson Controls’ fair share price between $37.15 and $41.96, not coincidentally the respective floor and ceiling of the trading range throughout 2011. JCI is currently communicating a sell signal based on fundamental valuation and technical indicators.

Johnson Controls JCI Valuation and Buy Sell Bands
(Click to enlarge)

Aside from shorting the stock, how can we bet against the realization of these wild projections? By using options to reduce our risk and enhance our return.

With the volatility index (VIX) near oscillating lows, it’s a great time to buy options (as opposed to sell them). The October $41 put looks very cost-effective at $2.20, especially if you pair it with as short $39 August put for $0.65 to create a calendar spread, which you could roll forward for September and October. This would allow you to sell a total of 3 different spreads for, say, a total of $1.75 (possibly even higher as the price moves south and volatility increases.

The next two months’ transactions could even be sold at the $38 strike or lower, widening your potential profit range. By October, you’re holding a nearly-paid-off spread that captures $3 worth of movement for about $0.50 in net cost. A nice 5-bagger if the stock moves to $38 or lower, or a well-insured, limited loss if the JCI continues north.

As with all options transactions, be aware of your leverage and at-risk capital. Don’t over-leverage into a position, but use just enough to get the proper amount of exposure in your portfolio. For example, 100 shares of JCI will cost $4,200, but the options transactions I described above will only consume $155 from the outset for the same exposure. Place the remaining $4,045 in a low-risk allocation, and you have much less capital at risk, for the same exposure to our target valuation range.

How else would you use options to play JCI right now?

Disclosure: I am short JCI.

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