Tuesday, December 4, 2012

Morning Update

Yesterday markets sold off on an exceptionally poor ISM manufacturing number which was reported at 49.5. Readings below 50 indicate contracting business activity. This comes on the back of poor durables goods orders and PPI last week, all of which suggest the US is headed for a recession. However, at the moment traders are preoccupied with budget negotiations going on in DC. On Friday traders will be watching the November unemployment report, though the reading could be distorted by Hurricane Sandy. Next month’s ISM manufacturing, unemployment, PPI, and durable goods orders will be extremely important because they will either confirm or deny the slowdown seen in the most recent data.

Yesterday fiscal cliff worries were at the forefront of traders’ minds, which sent the S&P 500 down 0.5% on the day. Should the US go off the cliff, there is a high probability of a recession in the near future. This has option traders playing defense ahead of the New Year by selling out of the money puts on consumer staples like PepsiCo. Yesterday a trader sold 1,760 Jan. 67.5 PEP puts for $0.45 with the stock at 70.24. This is a bullish trade that will profit if PEP is above 67.05 (4.5% lower) at January expiration in 45 days.

Option traders sell puts on stocks they are willing to own at the strike price. If the stock appreciates and is above the strike at expiration, the trader is able to book profits. If the stock is below the strike the trader is put to the stock and now has a long position at a price they are happy with. In this case, the trader has said that they are willing to buy PEP for an effective price of 67.05, and will collect an annualized 3.7% in option premium to patiently wait for that entry price.

Looking at PepsiCo’s chart, the 67 level looks to be a strong area of support. It is below the stock’s November’s low and coincides with an area of resistance the stock broke through last April. Pepsi, along with typical defensive plays like the other consumer staples and utilities, is likely to weather a fiscal cliff induced recession better than most stocks. PepsiCo owns a valuable portfolio of brands, including everything from Pepsi and Mountain Dew, to Frito Lay, Quaker, Gatorade, and Tropicana. The company has been focused recently on expanding its range of non-carbonated juices and sport drinks and hopes to grow its Global Nutrition division by 230% between now and 2020.

Weather the US jumps off the fiscal cliff or not, consumers are still going to buy soda and potato chips, making PepsiCo a good defensive buy. By selling a put this trader is being paid to wait for an entry he likes instead of chasing the stock higher and buying at poor valuation. At 67.05 PepsiCo will yield 3.2% and has strong growth prospects ahead no matter what the economy does. If the US is in recession next year, this is one of the companies you will want exposure to.

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