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American Electric Power Company (AEP) Trade Alert

By Jeff Brown on February 1, 2017

Action to Take:

Sell to Open the AEP March 17, 2017 $62.50 put

Buy to Open the AEP March 17, 2017 $57.50 put

For a net credit of $1.10 or more

Profit Potential:

Max capital at risk per spread: $500 – $110 = $390

Return on capital at risk: $110/($500 – $110) = 28%

Days to expiration: 43

Trade Thesis:

Utilities have been suffering a moderate decline in stock prices since mid-summer of 2016. Shown below is a chart of the Utilities Select Sector SPDR Fund (XLU). You can see the downtrend since summer in the chart (the orange channel).

This price action is a bit unusual because in historically low interest rate environments, utilities tend to do well. This is because while a 10-year Treasury might be yielding 2.5% (or less), the yield on a major utility player like Dominion Resources might be about 4%.

Utilities are seen as about as safe as a 10-year Treasury, but with a higher yield. In low interest rate environments, the debt burden that most utilities carry is much less of a concern. Debt is “cheap” to service when interest rates are low.

In mid-December, XLU broke out of its downtrend and had a big day on Tuesday with a strong breakout above its 200-day moving average (green circle). This typically indicates a bullish direction. 

This presents us with an opportunity to put on a bull put spread on one of the largest holdings of XLU, American Electric Power (AEP).

AEP is a giant, $52 billion public utility holding company with assets that provide electricity generation, transmission, and distribution.

Similar to XLU, AEP broke out of its downtrend in mid-December and has been trading between its 50- and 200-day moving averages. Since that time, it has bounced off support at around $62 twice and has the potential to break out above its 200-day moving average, which would be a very bullish indicator.

We can put on a bull put spread with a short option strike price right around that support level. We can put on the $62.50/$57.50 bull put spread for around $1.10, generating a 28% return on capital at risk in only 43 days.

While I typically like to see the short strike price farther out from the current price, the technicals of this trade are very strong, and the return compensates for the additional risk we take on.

Action to Take:

Sell to Open the AEP March 17, 2017 $62.50 put

Buy to Open the AEP March 17, 2017 $57.50 put

For a net credit of $1.10 or more

Profit Potential:

Max capital at risk per spread: $500 – $110 = $390

Return on capital at risk: $110/($500 – $110) = 28%

Days to expiration: 43

Regards,

Jeff Brown
Editor, Four Point Trader

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