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Could Transportation Companies Stall?

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At this point it looks like the group is overbought and ripe for a pullback.

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Shares of transportation companies are measured by the iShares Dow Jones Transportation Average (IYT), which has gained nearly 11% in the past four weeks and now sits near a 52-week high. This comes in the face of increasing oil prices and a suspect economic recovery. At this point it looks like the group is overbought and ripe for a pullback.

While I think the airlines are the most vulnerable to a pullback I'm looking at using the IYT to establish a bearish position. This exchange-traded fund is comprised of a swath of the large-cap companies covering various subsectors of transports. The two largest segments are delivery services FedEx (FDX) and UPS (UPS), which have a combined 21% weighting, and railroads such as CSX (CSX), Norfolk Southern (NSC), and Union Pacific (UNP) which have a combined 24% weighting. The third-heaviest weighting is the airline segment, with Continental (CAL), Delta (DAL), and Southwest (LUV) among others that account for 16% of the index.

While company-specific news has been generally trending positive, the macro backdrop doesn't seem to support further price gains. Rising fuel will be a drag on margins and demand from both businesses and consumers for shipping services, and travel could see a dip as outlooks remain cautious and spending restrained.

From a technical standpoint, the chart of IYT is near a double top at $76 level. And so are several of the individual components -- particularly the airlines, such as Continental, which tagged a double top at $21.50 level. The charts of FedEx and the various railroads all are heading into resistance levels. Taken together this looks like a good entry point for establishing a bearish position in the sector.

I've gone with a basic vertical put spread in the April expiration. By using a spread, I mitigate the impact of theta (or time decay), and vega (or changes in implied volatility). Another reason to use a spread is for a mechanical reason: The options in IYT are thinly traded, so using a spread instead of a straight-up purchase or sale of options can often help facilitate the execution of an order at what's closer to "fair" value. Market makers are more likely to be willing to come to the middle of the market on a spread, which is inherently a partially hedged position and carries less risk than an outright sale in which they'll look for a large edge that they'll need to offset, or hedge, using stock.

The strikes I chose were the purchase of the $75 put and sale of the $72 put for a $1.20 net debit. That cost is the maximum loss that would be incurred if shares are above $75 on the April expiration. The maximum profit is $1.80 if shares are below $72 at expiration. I like that the risk/reward is better than 2:1, and again, I think shares will have a tough time pushing above the recent 52-week high at $76, and first support level is at $72 a share.

It's not a position that's predicated on a big move down, nor is it one that will produce huge gains. But if the transports do lose altitude, you'll at least be able to afford to check your bags on your next trip.

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No positions in stocks mentioned.

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