Options Trade – Reynolds American (RAI)
Tuesday, September 18, 2012

Rounding Top Pattern on RAI Should Provide a Large Trading Profit!

**OPTION TRADE: Buy the RAI Jan 2013 40.000 put (RAI130119P00040000) at or under $0.70, good for the day. Place a protective stop limit at $0.20 and a pre-determined sell at $3.50.

by Ian Harvey

September 18, 2012

Introduction

Almost all stocks moved higher on the Federal Reserve's announcement of QE3 last week, but there were a few laggards. Traders often say that a rising tide lifts all boats, and it is true that the majority of stocks move up when the major stock market averages deliver gains of more than 1% in a day. The stocks that fall on a day like that could have deep fundamental problems and could be ready to drop sharply.

Looking at the stocks that fell on the day the Fed announced QE3, several stand out as short trade opportunities. One stock that appears very bearish in particular is Reynolds American (NYSE: RAI). While S&P 500 SPDRS (ARCA: SPY) gained more than 4% in the first two weeks of September, this stock fell more than 4% during that time.

Description

Reynolds owns R.J. Reynolds Tobacco Company, the second-largest tobacco company in the country. The company's brands include five of the 10 best-selling U.S. cigarette brands, well-known names like Camel, Kool, Pall Mall, Winston and Doral.

RAI may have popular brands, but they are in a tough market. Cigarette smoking is on the decline in the United States. According to USA Today, a 62-cent federal tobacco tax increase in 2009 resulted in historic lows for tobacco use -- just 18.9% of American’s smoked in 2011. The average cost of cigarettes nationwide is about $5.55 a pack although they cost more than $10 a pack in some areas.

Earnings

In the most recent quarter, RAI reported that sales declined by about 1% and earnings dropped more than 20%. The company needs to pay billions of dollars a year to the government under a settlement that ended years of tobacco lawsuits. RAI also faces a bill for hundreds of millions of dollars related to unfunded employee pension liabilities. These expenses will hit earnings and analysts believe that RAI will see annual earnings growth averaging only 7% a year in the next five years.

Technicals

The stock is trading with a forward price-to-earnings (P/E) ratio of 14, twice the earnings growth rate. Some analysts look at the ratio of the P/E ratio to the earnings growth rate, a measure known as the PEG ratio, to spot overvalued stocks. A PEG ratio of 1 is considered to be the fair value for a stock. A ratio over 2, like we have in RAI, is high and indicates the price might have gotten ahead of the company's fundamentals.

The chart shows a rounding top pattern has formed and the downtrend in RAI may have already started. The initial price target on the downside is $34, more than 22% lower than the recent price of RAI.



The pattern in the chart above took three months to form, and targets are often reached in about the same amount of time that it took the pattern to form. That makes January 2013 options the best choice to profit from the expected price drop since that allows four months to reach the target price.

Therefore, to exploit the expected breakdown, and based on the facts above the following options trade is recommended…..

**OPTION TRADE: Buy the RAI Jan 2013 40.000 put (RAI130119P00040000) at or under $0.70, good for the day. Place a protective stop limit at $0.20 and a pre-determined sell at $3.50.


”Success is simple. Do what's right, the right way, at the right time.”


Option Tip for your Success!
Options traders are not successful because they win.
Options traders win because they are successful.



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