Options traders have been largely bearish toward Caterpillar Inc. (CAT: sentiment, chart, options) recently, with put traders dominating the stock's Schaeffer's put/call open interest ratio (SOIR). Currently, this ratio of puts to calls among near-term options rests at 2.19, meaning that puts more than double calls for the front three months of options. Furthermore, this ratio ranks just four percentage points shy of an annual bearish peak, underscoring this rising pessimism from the speculative options crowd.
The bears have retained control in the options pits today, as CAT has seen heavy put volume at its September 37 and 42 strikes, according to our Intraday Volume Explosion List. Some 16,000 of these bearishly oriented contracts have changed hands on CAT's September 37 strike, while a respectable 8,000 contracts have traded on the September 42 put. Open interest at these front-month options rests at 2,012 contracts and 4,026 contracts, respectively.
Drilling down on the activity at CAT's September 37 put, I noticed that a block of 13,400 contracts traded at 10:26 a.m. Eastern time on the Philadelphia Stock Exchange for the bid price of $0.41. This trade was marked "spread." The second leg of this position was found on the September 42 put, as a block of 6,700 contracts traded at the same time on the same exchange for the ask price of $1.17. This block was also marked "spread." Given this data, we could be looking at the initiation of a vertical ratio put spread, or a debit spread, on CAT.
The Anatomy of a Caterpillar Vertical Ratio Put Spread
Breaking down this vertical ratio spread position, the trader would have purchased 6,700 September 42 puts for a total outlay of $783,900 -- (1.17 * 100) * 6,700 = $783,900. Minus the sold leg of the debit spread, CAT would need to fall about 14.5% from Friday's close at $47.78 to $40.83 per share in order for the position to reach breakeven at expiration. Furthermore, the maximum loss on this position is limited to the initial investment of $783,900.
However, the second leg of the debit spread helps to offset the cost of the overall position. Specifically, the trader sold 13,400 September 32 puts for a total credit of $549,400 -- (0.41 * 100) * 13,400 = $549,400. Combining this leg of the trade with the purchased September 42 put lowers the total cost of the entire position to $234,500 -- $783,900 - $549,400 = $234,500.
The addition of the sold September 37 put also lowers breakeven on the trade. To arrive at breakeven, we subtract the credit received from the sold September 37 put from the debit incurred by purchasing the September 42 put. Remember, we have to account for the fact that we have two September 37 puts for every one September 42 put. Therefore, we arrive at a cost of $0.35 -- (0.41 * 2) - 1.17 = 0.35 -- or $35 per contract. As a result, breakeven for the position now rests at $41.65 per share, with the trader now needing CAT to fall roughly 12.8% from Friday's close.
As with a normal vertical put spread position, the maximum profit is achieved when the underlying stock drops to the sold strike, which would be the 37 level in this case. However, since twice as many September 37 puts were sold, this spread position will lose money after CAT drops below $37 per share. Once CAT breaches the 37 level, the 13,400 sold September 37 puts are only half hedged by the 6,700 purchased September 42 puts. As such, while 6,700 of the sold September 37 puts are hedged, and therefore balanced on a point-for-point move below the 37 level, the remaining 6,700 September 37 puts are not hedged. The trader begins to lose money on these contracts as CAT declines below the 37 strike. Below is a chart for a rough visual representation of the trade's profit/loss scenario:
The chart below has been updated to reflect the correct profit/loss for this trade. The initial chart included with the article was incorrect.
Implied Volatility
After a normal vertical put spread has been entered, increasing implied volatility is usually neutral to the overall position, as it lifts the value of both the sold option and the purchased option. However, rising implieds for this position could be detrimental, since the trader has sold more contracts than he has purchased. Currently, implieds for the September 37 put arrive at 65%, while the implied volatility for the September 42 put rests at 56%. CAT's one-month historical volatility is currently perched at 49.76%, meaning the aforementioned options are moderately expensive at the moment.
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