After the big rally off the March lows, I am running into the same scenario with many stocks – I like them, but I would like to own them at a better entry price. Over the last few weeks, I have looked at so many stocks where the fundamentals look good, and there is some sense of pessimism from the sentiment indicators, but the stock has run up so much in the last few months that I don’t think it’s a good time to buy the stock.
One such company is Eli Lilly (NYSE:LLY). Under these circumstances, I have several scenarios I can consider. I can simply sit back and wait to see if Eli Lilly pulls back a little. Or I can write an out of the money put on the stock and get paid to wait. I will lay that trade out later in the article. First, I want to look at the stock and the company and explain why I would consider such a strategy.
One of the most important factors I consider before writing puts on a stock is whether or not I want to own it. Is it a fundamentally sound company? Is it trending higher or lower? I won’t even consider writing puts on a company with poor fundamentals or one that is trending lower, even if it has good fundamentals.
Eli Lilly meets both of those requirements.
Lilly has seen its earnings grow by an average of 19% per year over the last three years. The company saw earnings increase by 32% in the first quarter, and earnings are expected to increase by 6% in the second quarter.
Revenue has been flat over the last few years, but it did increase by 15% in the first quarter. It’s expected to increase by 3.7% for the second quarter and by 7.4% for the year.
One area where Lilly does especially well is in its management efficiency measurements. The return on equity is incredibly high at 89.6%, and the profit margin is well above average at 28.8%. The current valuation is very reasonable with a trailing P/E of 24.9 and a forward P/E of 22.3.
Trending Higher, but the Trend has Stalled Recently
Lilly hit a low of $116.51 back in March and then rallied over 40% in five weeks. After peaking at $164.13 in April, the stock has drifted lower over the last few months and is currently hovering just over $150.
The 10-week RSI and the weekly stochastic indicators were both up pretty high when the stock peaked in April. The stochastic indicators were in overbought territory, and the RSI was very close. The indicators have since pulled back down and are now out of the overbought zone.
You can see on the chart how I have connected the low from last October and the low from March to form a trend line. The stock hasn’t come back down to test that trend line yet, so we don’t know yet whether it will act as support or not. I do like the fact that the line is close to the potential support in the $129 range, which was the high in March ’19.
The red horizontal line isn’t meant to show that potential support, rather it is pointing out the entry price we would get with the put writing strategy I will lay out shortly. The fact that the trend line, the horizontal line, and the 52-week moving average are all converging in the $125 to $130 range makes me think this area will be a very strong support level for the stock.
Analysts are Far More Skeptical Than They Should Be
I mentioned the sentiment indicators earlier and how I like to see some sense of pessimism toward the stock. From a contrarian viewpoint, bearish sentiment or skepticism are good because it means there are investors that can switch camps and help push the stock higher. If everyone is already bullish, there is little chance for analyst upgrades or short-covering rallies, etc.
In the case of Eli Lilly, the overall analysts’ ratings are much lower than they should be, in my opinion. There are 15 analysts covering the stock at this time with seven “buy” ratings, seven “hold” ratings, and one “sell” rating. If we view the ratings in terms of the buy percentage, Lilly’s buy percentage is only 46.7%, and that is below average. It isn’t terrible, but it’s lower than it should be for a stock that has performed as well as Lilly.
The short interest ratio is at 1.7 currently, and that is a little low. I have seen a number of stocks where the short interest ratio is lower than normal in recent months. The big selloff in March caused a spike in the average daily trading volumes and short interest fell as short sellers covered. Lilly saw its short interest drop by 15% in the most recent reporting period.
Option traders are leaning toward the bearish side with a put/call ratio of 1.30. There are 60,768 puts open and 46,874 calls open at this time. The ratio is a little higher than the average stock, and it is a little higher than it has been over the last few months. This suggests that option traders are becoming more bearish.
Between the buy percentage being low and the put/call ratio being high, this gives us two different indicators that are showing signs of pessimism. The short interest ratio is a little low, but not low enough to cause concern.
How I Suggest Playing Eli Lilly Currently
I think I made it pretty clear with the title of the article that I am bullish on Eli Lilly. The fundamentals are strong, the stock is trending higher, and there is enough skepticism to help push the stock higher.
If you already own the stock, congratulations – you own a good stock on a good company, and unless you bought in the last few weeks, you are probably sitting on gains. If you don’t own the stock yet, you can sit back and wait to see if the stock drops back down a little, but that doesn’t gain you anything in the interim.
If you don’t own the stock, I suggest writing puts on the stock. Right now, the August 130-strike puts are priced at $2.05. That means you would get $205 for each contract you sell. By selling these options, you are required to put up margin of $1,505 and after taking out the $205 collected, your net margin requirement is $1,300. If the options expire worthless, your return on margin is 15.8%.
Let’s look at several possible outcomes for this trade. If the stock goes up another 10% from here, that’s good for shareholders, but it doesn’t change your return on your put sell at all. If the stock drifts sideways for the next two months, you still keep the $205 and your return remains the same. If the stock drops 10% from here, your puts are still out of the money, and your return remains the same.
The only way you lose on this trade is if the stock drops below $127.95. That’s the strike price of $130 minus the premium you collected. If the stock drops below the $130 level, the stock put to you. That means you are obligated to buy the stock at $130. Even if the stock is trading at $100, you’re obligated to buy it at $130 – if you haven’t bought the options back.
In other words, the stock needs to drop by 14% for these options to be in the money. If the stock gets put to you, you now own a quality stock at a steep discount from where it is trading currently. In this case, the $130 area has several different forms of support that could come in to play, and that’s why I chose that strike price.
One thing to keep in mind is that you should only sell one contract for every 100 shares of the stock you want to own. You will also need to have the money in your account to cover the purchase of the stock. In this case, that would be $13,000 for every 100 shares of stock.
There are two dates you will want to keep in mind should you decide to make this trade. Second quarter earnings results are due out on July 30, and as we know, stocks become more volatile around earnings reports. The stock should also go ex-dividend around August 14, and that will cause the stock price to drop by the amount of the dividend. The August options expire on August 21, one week after the ex-dividend date. The current quarterly dividend for Lilly is $0.74.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.