The LEAPS Trader
105 W. Monument Street
Baltimore, MD 21201
Friday, December 08, 2006
Email – #350
** The Best Time To Buy An Umbrella
In Florida, where I live, there is a provision in insurance policies that do not allow you to buy hurricane insurance during a storm… Makes sense.
Like any business, insurance companies are in business to make money, not pay it out. This past hurricane season was a yawner, thankfully, with virtually no calamities to affect the bottom lines of insurers. The culprit was El Nino, a cooling trend in the Pacific waters that effects weather all over the world. In El Nino years, hurricanes in the Atlantic are not as fierce or numerous. The prior year, when we had a record hurricane season, there was no calming effect from El Nino.
What’s in store for 2007? The most recent forecast is for a much more active hurricane season than 2006.
If we do have a more active hurricane season, the same insurers that had a stellar, rebuilding year in 2006 are going to face pressure in 2007. However, by the time we know this for a certainty, it will be too late because their shares will already be tanking – and the price to get involved in the trade will be too expensive.
So the time to buy into a hurricane trade is now, when the weather is nice.
For this trade, we are going to go short one of the biggest carriers in he country, Allstate (NYSE: ALL).
To be sure, the company is healthy and has taken provisions to deflect some of the hurricane liability in Florida – But that is not the case for the rest of the Atlantic seaboard or the Gulf Coast. And because the industry is viewed as “one” industry, the occurrence of a disaster is perceived to be negative for all insurers.
Also, it does not hurt that insurance shares are trading at their highs, giving us the opportunity to make a very cheap bet. And make no mistake – this is a bet.
We will use a bear spread for this trade, buying one put option at a higher strike price and selling a put option with a lower strike to offset some of the cost. The objective here is for the lower strike to expire worthless while the higher strike gains.
Here is the play:
BUY the Allstate January 2008 $60 LEAP PUT option (WLZ-ML) currently trading for $2.15. Against this position SELL the January 2008 $55 PUT option (WLZ-MK) currently trading for $1. Your cost should not be more than $1.15. Your upside on this trade is $5 for every $1.15 at risk or $3.85 per spread. Your downside is $1.15 if held until expiration. Use a limit of $1.20 for this spread.
Good investing,
Karim
