Pairs Trade – Buy CAT Stock, Go Short DE Stock Now!

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If the market is always right, but at any given time also allows for both bulls and bears to thrive, diverging conditions at Caterpillar Inc. (NYSE: CAT ) and Deere & Company (NYSE: DE ) could be pointing to a solid pairs trade opportunity.

Let’s review why these two similar companies are currently completely different animals both off and on the price chart – and how to approach CAT and DE as limited-risk bull and bear verticals using the options market.

The Bull: Caterpillar Inc. (CAT)

Construction and agricultural machinery play CAT has enjoyed a solid 2016 for bullish investors riding Caterpillar shares to a year-to-date gain of around 20% and more than 3x the price gain of the S&P 500 Index .

CAT benefited from a recent earnings beat which bested Street views by nearly 14% and in the process, sending shares to fresh year-to-date highs. But Caterpillar has also profited from forward-looking or “better-than-feared” investor optimism.

The reactive bid bulldozed its way past a 16% year-over-year sales decline, as well as reduced full-year top and bottom-line guidance. The soft outlook for CAT is largely due to  persistent weakness in key global segments within the oil and gas, mining and rail industries.

Part of investors’ enthusiasm could be Caterpillar’s attempt to come clean early, thereby setting the company up for a future earnings beat . As well, a beefed up commitment to its cost restructuring program amidst a difficult operating environment, may have helped with CAT stock’s bullish performance.

CAT Stock Technical Forecast

Click to Enlarge  The weekly CAT stock chart shows a name which is trying to trend higher in 2016 and failing a market meltdown, should continue to build on that strength.

Technically speaking, on the heels of this year’s breakout above its 2014 – 2015 downtrend line, CAT’s current higher high pattern will need to be followed by a second higher low to confirm a classic bullish uptrend.

Currently, an overbought stochastic signal supports some backing and filling for CAT stock. However, it’s suspected any pullbacks will be shallow enough to hold and confirm a new uptrend for shares of Caterpillar.

CAT Bull Put Spread

Regarding an options strategy for CAT, a Sept $ 77.50/$ 75 bull put spread for a credit of 40 cents or better is attractive. Risk for this vertical is set at $ 2.05 if CAT stock should fall below $ 75 at expiration. On the flipside, a return of 22% is possible if Caterpillar remains above $ 77.50.

Given shares are near $ 81.85 in early Tuesday trading, that’s a safety of margin of 5% from current levels and fits in nicely with the described technical forecast for CAT.

The Bear: Deere & Company (DE)

For the second and bearish portion of our pairs trade, DE stock, and much to the chagrin of dividend chomping bulls, is for all intents and purposes focused on corn.

With weak pricing for corn and heavy reliance on the commodity, sales of “farm toys” for the agricultural equipment giant (as one academic puts it) have been weak and don’t appear to be getting better any time soon.

Some analysts and traders in the investment community have been anticipating a trough in 2016, but in late July DE did take the step of warning and cutting its full-year sales forecast in front of this month’s earnings announcement.

DE stock does have the backing of Warren Buffett’s Berkshire Hathaway Inc.  (NYSE: BRK.A , NYSE: BRK.B ) which recently increased its stake to 7.5%. Nonetheless, the long-term, value-based shop may be backing up the tractor on shares of Deere at even lower prices if a conspiring and bearish chart has any say in the matter.

DE Stock Daily Chart Forecast

Click to Enlarge  DE is looking a bit like a deer in headlights or maybe a bear in the head and shoulders spotlight per technicians. Similar to CAT, shares of Deere had been rallying in 2016 after a volatile breakout of its prior downtrend from 2015. Now though, it’s a different matter entirely.

DE stock has confirmed a bearish continuation head and shoulders pattern by breaking neckline support. From here, DE appears to be a shoo-in for a retest of its January low.

A pending test of January’s low of $ 70.16 offers bearish traders about 10% of downside, while a technical stop above $ 79.99 and recent pivot high during its neckline breakdown, equates to a reward-to-risk profile in DE stock of around three to one.

DE Bear Put Spread

Checking DE’s options board and looking to improve this profile with a limited risk strategy that fits the situation, the September $ 77.50 / $ 72.50 bear put spread is attractive.

Priced for around $ 1.65 with shares at $ 77.80, this limited risk spread offers profit potential of $ 3.35 or a return of 200% below $ 72.50 in DE stock.

To generate the max payout, shares of Deere will need to have fallen by nearly 7% at expiration; however, given the weak forecast both off and on the chart and earnings in mid-August, this spread has sufficient time and catalyst to supply a nice bearish harvest.

Investment accounts under Christopher Tyler’s management do not currently own positions in any of the securities or their derivatives mentioned in this article. The information offered is based upon Christopher Tyler’s observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. For additional market insights and related musings, follow Chris on Twitter @Options_CAT .

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