Sunday, August 05, 2007

CAT Puts Are a Better Way to Short the Dow Jones

From a purely technical standpoint, the broad market and many individual stocks are headed decisively lower. As you can see in this Dow Jones Industrial Average weekly chart below, the index has broken and closed below previously strong support in the 13,250 area. Using a Fibonacci 61.8% pullback one gets a target of 12,735, the 40 week (200 day) moving average lies at 12,817 and the prior high in February was 12,796. So I'm going to average these targets an round up to suggest the Dow is headed for 12,800.

Now the federal reserve is meeting early next week with their statement at 2:15PM Tuesday but there is no economic data to be released Monday. I'm thinking the momentum we saw Friday will continue Monday and some may be trying to pressure the fed (via a broad market decline) into a rate cute or at least towards a change in bias towards a cut later this year. Of course this is speculation, but with Cramer begging on TV for a rate cut there are clearly those who are desperate to get one. However, if the fed raises rates or talks about sympathizing with the bond speculators who are loosing their ass right now, we may see a powerful short covering rally Tuesday. For this reason I suggest you keep tight stops on all shorts.

There are a few ways to play this decline, but my favorite is to buy puts on CAT. I mentioned CAT a few weeks ago as a short which worked out great. After a dead cat bounce (pardon my pun) the stock was able to briefly regain it's 50 dma before closing below it once again on Friday.

The reason why I like shorting CAT as a way to play an industrial decline is threefold. First, they reported earnings a few weeks ago that disappointed wall street with an unexpected 21% earnings per share decline. CAT is somewhat levered to residential construction in the US, which is part of the reason why earnings were so bad. Second, CAT is one of the 30 DJIA stocks and was until recently the second biggest gainer in the group for 2007. So it trades very closely with the index which I believe to be headed lower. Finally, the options on CAT are highly liquid and have a relatively low implied volatility (they are cheap). Volumes are typically in excess of 1000 on near the money contracts and spreads are frequently less than .05. You can get in and out of those options quickly without having to pay a spread penalty.

From the weekly chart above you can see how CAT has broken it's 10 week (50 day) moving average after a sustained rally a few times in the last two years (I've circled those breaks in blue). In each case this break was followed by a test of its 40 week (200 day) moving average in 2-3 weeks. The indicators and candlesticks looked similar in those situations to how CAT looks right now and based on the CAT chart alone I would say it 's headed to at least $70. However, since CAT trades so closely with the DJIA, I would sell those puts when the DJIA hits 12,800. Although, its worth noting that my target on the dow is it's 200 dma and my target on CAT is it's 200 dma, so why shouldn't these events occur simultaneously? If they both reach their targets CAT will have fallen substantially further on a percentage basis, hence CAT is a better way to play the drop in the dow.

As a side note, the glorious momentum stock DECK has lost it's momentum and fallen completely off the IBD 100 after being number #6 just two weeks ago. This stock is still above 100, a miracle of miracles for the longs who own it, and I think it is about to get slammed big time. Especially with the growing concerns that consumers are going to feel the pinch with all thats going wrong with credit and housing, investors may be seeking to take profits on this low floater. Tough decision: Pay mortgage or buy a new pair of UGG sheepskin booties...

Any thoughts on the new logo? Comments on the poll? If you haven't yet, please take a moment to vote in poll on the right. There are many more people stopping by than have voted. Happy trading next week.

Disclosure: I own DECK and CAT puts.


JJ2000426 said...

Be careful with CAT. It is not just residential construction. CAT is also in mining equipment, which is a boom due to commodity boom. Their quarterly earnings may be down but the sales revenue is actually UP. There are tons of good shorts out there so why CAT?

Who SOLD OUT a piece of national treasure vital to our survival, to Russians, dirt cheap? On paragraph 4.

Watch out SWC on monday for earnings release after hour. Crooks knocked down SWC from $16.47 to $8.56 in less than 3 months, for no good reason. Maybe they want to sell the remainder to Russians cheap?

Deeply oversold, I expect a blowout SWC quarterly earning, and from here SWC MUST have a dramatic reversal and a great rally on the good earnings. Don't let go of the opportunity!

pythagoruz said...


I hear ya on better shorts, I was just trying to make the point that if you want to short the dow jones then CAT is a better way to go. If the dow jones can get over 13,500 I have no beef with the market and buying CAT puts would no longer make sense.

I still feel like the CAT chart looks bearish but the dow is trying to reverse out of this move down, so I'm not so hot on the idea anymore.

As far as SWC, the chart looks pretty bearish to me, definitely in a downtrend. However, it could rally back up to the 50 dma when/if a bottom forms. From the look of the chart the market wasn't too pleased with earnings but it closed higher than it opened (a positive). Right now the chart is making no argument to buy the stock that I can see, but I haven't looked at the fundamentals.

pythagoruz said...

On DECK, suprisingly it was able to make a new high today on heavy volume the last two days. This tells me that the momentum in DECK is alive and well. I certainly don't want to stand in front of that freight train even though I might have problems with the story/valuation. I exited my puts over the last two days, some for profit, some for loss.

Frankly, the stock broke out on above average volume and I have no interest in shorting the stock anymore. If it forms another top later on down the road, so be it, I might try shorts/puts again. But for now the trend is decisively higher. I wouldn't be against the idea of going long the stock either, especially with the squeezer potential it has. Watching the chart action, many people were selling or shorting over the past month and they will only add to the upside here. But that trade is not for me.

I'm putting up a white flag on DECK.

pythagoruz said...

Great, the day after i throw up a white flag DECK crashes 10 points. Sometimes my timing is questionable...

If it breaks 100, im back in.