New Trade CHK – A Shorter Duration Bet for Tonight’s Options Action

by Enis May 25, 2012 3:29 pm • Commentary

Here is a quick preview of what I will be discussing on Options Action tonight on CNBC at 5pm et:

Dan and I have been following the CHK story closely for more than a month now, and as Dan laid out in his trade idea earlier today, we think there is the potential for more downside.  One additional point that I would make is that 5 yr CDS is now near the same levels as during the financial crisis in 2008:

However, this time around, it’s company-specific issues that are causing the spike in bets against CHK bonds, as opposed to general macro concerns in 2008.  CHK has $20 billion in debt (vs. a $10 billion equity market cap), and it is undergoing an asset sale program to help pay off its near-term debt.  As Dan said, we don’t think activist investors are a panacea for a deteriorating balance sheet, and here’s the way I’m going to play it on the show tonight:

TRADE:

CHK ($15.90) Bought Jul 14/12 1×1 Put Spread for .50
  • Bought 1 Jul 14 Put for 1.10
  • Sold 1 Jul 12 Put for 0.60

Break-Even on Jul Expiration:

  • Profits of up to 1.50 btwn 13.50 and 12.00, max gain of 1.50 at or below 12.00
  • Losses of up to 0.50 btwn 14.00 and 13.50, max loss of .50 above 14.00
TRADE RATIONALE: This is a shorter duration trade than Dan’s Jan13 structure, and I am going to play it in smaller size because it needs to move 20% over the next 2 months, but it’s much better than shorting the stock given the volatile nature of this story and offers decent risk/reward if CHK revisits the lows of last week at any point in the next 2 months.
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Dan’s post from earlier today:
Earlier in the month we tried playing CHK  (15.82 ↑1.57%) from the short side (see earlier comments below) as we thought the news was likely to get worse before it got better, and given how bad we perceived the news concerning the company, we thought that implied vol was just too low.

Last week the stock made a 3 year low and has since recovered almost 20% aided by reports that Carl Icahn took a large stake in the company.  We are in the camp that the addition of agitating activist investors is not always a shareholder friendly event (see YHOO).

Our Current View on CHK:

In a nutshell, the story is broken.  To Summarize:
  • Its founder, Aubrey McClendon is under serious heat for multiple ethical breaches ($1.1 billion personal loan against oil and gas well stakes, ran a $200 million hedge fund on the side that traded in same marketplace as CHK)
  • Reported weak earnings at the beginning of May due to low natural gas prices.
  •  As stated above the stock has recently rallied 20% as Icahn reportedly has bought 4% of the company and other shareholders are pushing for better corporate governance (Southeastern, CALPERS).
But CHK has $20 billion in outstanding debt and a steep climb ahead of it just to sell enough assets to pay off near term debt.  The company’s bonds have rallied much less than the stock, and still imply significant worries.

We remain bearish and believe the news is likely to get worse before it gets better and we found a creative way to get short exposure with defined risk out to Jan13 expiration.  We are kind of trading junkies if u haven’t noticed, so we traded both structures, but we particularly like the first as we think the odds of making a lot of money on this trade are far better than the 2nd.

TRADE 1: Outright Bearish Bet or a great way to get protection for a long with limited risk.

CHK ($16.00) Bought Jan13 12.50/7.50 1×2 Put Spread for .50
  • Bought 1 Jan13 12.50 Put for 2.36
  • Sold 2 Jan13 7.50 Puts for a total of 1.86 (.93 each)

Break-Even on Jan13 Expiration:

  • Profits of up to 4.50 btwn 12.00 and 3.00, max gain of 4.50 at 7.50
  • Losses of up to .50 btwn 12.00 and 12.50, max loss of .50 above 12.50 on the upside.

-The downside risk is a little different. The trade actually loses money below 3.00, but we anticipate getting out of the structure well before then if the stock ever gets into the single digits. For completeness though:

-Losses between 3.00 and 0, max loss of 3.00 (premium paid of 0.50 plus 2.50 of downside risk) if stock goes to 0. Which we assign a low probability of, but still your max risk on the extreme downside is defined.

And/Or

 

TRADE 2: Black Swan Structure

CHK ($16.00) Bought the Jan13 10/5 1×2 Put Spread for .60
  • Bought 1 Jan 10 Put for 1.56
  • Sold 2 Jan 5 Puts for a total of .96 (.48 each)

Break-Even on Jan13 Expiration:

  • Profits btwn 9.40 and .60 make up to 4.40, max gain at 5.00, make full 4.40 or 7.3x your money.
  • Losses of up to .60 btwn 9.40 and 10 and btwn .60 and Zero, .60 IS YOUR MAX RISK.

Trade Rationale: The Jan13 1×2 put spread risks 60 cents to make $4.40 max payout, and is a great risk/reward way to play for an implosion in the stock, and/or initiate protection in case CHK’s asset sales don’t go as planned, and the bond market’s worst fears come to pass. It gives you until past the end of the year for your trade to work.