No. 4 Auto Insurer Is My No. 1 Sector Pick

Sales of new vehicles hit their fastest rate in almost eight years in June, rising to an annualized 17 million. Analysts had been expecting 16.3 million to 16.4 million units, and many are now upping their forecasts for the second half of the year.

Record auto sales are likely to fuel demand for related industries such as car parts and tires (see my most recent trade). But one area traders aren't talking about much is insurance.

When consumers purchase new cars, insurance premiums tend to increase because of the cost of the vehicle. Additionally, financed and leased vehicles typically require elevated coverage. This equates to more revenue for insurance companies as long as claims don't get out of control.

GEICO is the undisputed king when it comes to growth. In 2013, the insurer saw auto premiums jump 11.3%, as it surpassed Allstate (NYSE: ALL) to become the country's second largest insurer.

State Farm, a mutual company owned by the policyholders who buy its insurance, is No. 1, and No. 2 GEICO is a subsidiary of Berkshire Hathaway (NYSE: BRK-B), so we can't invest in them directly.

As for Allstate, of the major auto insurers, it saw the lowest year-over-year increase in insurance premiums, up only 3.4%.

When it comes to growth that we can invest in, Progressive (NYSE: PGR) is the top dog. While it is the fourth largest auto insurer, it showed the second largest increase in auto premiums in 2013, rising 6.5%.

Progressive is going after competitors' precious market share with its witty ad campaigns, aggressive pricing and unique insurance plans. The company is also among the best at keeping expenses down and payouts low relative to income, second only to GEICO. 

Progressive reports earnings on a monthly basis unlike the normal quarterly cycle for most companies. The increased frequency tends to reduce the "surprise" factor of the reports and allows analysts and investors to update their estimates with more speed and accuracy. 

I believe PGR's performance over the next few earnings reports will be strong. Indeed, analysts have also been lifting estimates leading into the June report, scheduled for later this week.

An earnings hiccup and special $1 dividend sent shares skidding lower in January, but the stock has maintained a bullish channel since then. We are very close to seeing a breakout back above the 200-day moving average, which should at the very least take PGR to $26.

PGR Stock Chart

The next three reports are scheduled to be released before the market open on July 10, Aug. 13, and around the week of Sept. 10. I expect them to show strength and earnings growth along with the automotive sector.

PGR is also a defensive play in the sense that it's not a volatile stock. In fact, the monthly average trading range is less than 8%. So we will use options to amplify our returns while reducing risk. 

PGR Call Option Trade

Today, I am interested in buying PGR Nov 23 Calls for a limit price of $2.55.

PGR Call Option
Risk graph courtesy of tradeMONSTER.

This call option has a delta of 78, which means it will move roughly $0.78 for every dollar that PGR moves, but it costs one-tenth the price of the stock.

The trade breaks even on expiration at $25.55 ($23 strike price plus $2.55 options premium), which is 1.8% above current prices.

I am looking for PGR to move to the $26 area in the next week or so, which would equate to at least $3 in option premium. This will be our first target, and it is a good idea to set a GTC limit sell order for half of your position here.

From there, I am looking for the next few earnings reports to propel PGR back up to the $27.35 level, so we will place our second target at $4.10. 

For our stop-loss, we are going to allow about a 70% drawdown in value because we are holding over several earnings reports, which can be volatile times. Be sure to adjust your allocation to this trade accordingly. 

Recommended Trade Setup:

-- Buy PGR Nov 23 Calls at $2.55 or less
-- Set stop-loss at $0.80
-- Set initial price target at $3 for a potential 18% gain in one week
-- Set secondary price target at $4.10 for a potential 61% gain in a few months

If you have a question or comment about today's strategy, please send it to editors@profitabletrading.com.

[Market Outlook] Why I Can't Stop Talking About The 200-Day Moving Average
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Many investors hold strong opinions about the 200-day MA... but is it actually important?