Trade Update – CHK: Updating Our View on “Disaster” Trade Structures

by Dan August 6, 2012 2:05 pm • Commentary

Update Aug 6th, 2012:  So we got a little geeked up on CHK back in May when it seemed that the unfolding management indiscretions of the founder and CEO, was going to lead to a string of inquiries from the likes of the SEC and class action suits from investors, which led us to our favorite “terminal short” structure, a 1×2 put spread with little or no tail risk, not once but 2x (see previous posts below).  

Event: The company reports Q2 after the close tonight, the implied move in the options market is about 7.7% vs the 8 qtr avg of about 5.25%.

Unusual Activity:  Last week there was some put activity that caught my eye, concentrated in Aug and Oct:

-Friday there was a fairly large buyer of the Aug 10th weekly 17 Puts, the largest block was 5700 for .27 (stock ref 18.60), but 7700 traded on the day and by all indications this appeared to be opening.  Also on Friday a bunch of Oct 16 & 13 Puts traded electronically, 10k of the 16s in two lots at 1.03 and 9k of the 13s at .47, this appeared to be a Put Spread.

-Thursday there was buyer of the Aug regular 18/15 Put Spread 2000x for .79 (stock ref 17.88), this also appeared to be opening.

-Tuesday there looked to be someone rolling out of 8k of the Aug 17 puts, selling them at .40 and buying 7k of the Aug 18 Puts for .65  (stock ref 18.91)

-Monday there was a buyer of 5k  of the Oct 16 Puts for 1.15

Sentiment: The street still fairly mixed on the name with 13 Buys, 20 Holds and only 1 Sell with an avg 12 month price target of about $23.50.  Short interest sits at about 13% of the float.

Bank of Montreal downgraded the stock this morning from a Buy to a Hold largely on what they categorize as fundamental risks that remain aside from the corporate governance issues.  In a note to clients this morning, BMO analyst Dan McSpirit (I think that is French Canadian for “lots o’ Spirit) had the following to say about why he is moving the sidelines in the name after upgrading the stock to a Buy back on April 30th:

The challenge remains for the company to raise capital through asset monetizations and cut spending in amounts sufficient to plug the cash flow gap and reduce the cash burn. We offer no insights here on the progress the company may or may not be making on the divestiture front, only offer that coming up short of expectations could be met by selling pressure, especially so in an already pressured commodity price environment. Of course, success on this front represents the chief risk to our downgrade. Our point here is that developments in raising capital/cutting capex must offset the reality of less growth and pressured margins. A reminder of the cash burn in 2Q12 results and the challenge of debt reduction are also supportive of our change in rating. (The impairments we’ve seen other natural gas producers take this earnings season are another reminder of the challenging commodity price environment, however historical the look when valuing the assets.)

My Positioning: I am currently long the Jan 12.50/7.50 1×2 Put Spread that I bought for .50 (stock ref 16.00) and the Jan 10/5 1×2 Put Spread that I bought for .60 (stock ref 16.00).  Both trades were playing for the one of the worst case scenarios where even after activists have gotten involved relieving the CEO of his chairman title and adding outside board members, the company still faces the challenges of recapitalizing the company the very issue that had started to weigh on the stock prior to the issues surrounding corporate governance.

Now since putting these trades on almost 2 1/2 months ago, and the stock up about 11%, both spreads are worth about half what I paid.  But given the nature of the structures, and the rapidly declining influence of the lower ratio strike, it would only take a couple tape bombs to get these spreads back to break-even.  At this point I want stick with both trades, with an eye to take off the 10/5 1×2 on the next move lower, near break-even and leave on the one that has a far better probability of making money.

Obviously I have no clue what the company is going to report and say about their in process restructuring, but expectations are not exactly low at the moment.  With implied vol very elevated, it is tough to make a directional view in short dated options, but calendars could make sense for those with a directional bias.

But I would add that these sorts of 1×2’s could serve as cheap disaster protection for long holders in the name.




Original Post May 25, 2012 @ 10:48:  (CHK): A Trader’s Dream, An Investor’s Nightmare, Part 2

Earlier in the month we tried playing CHK 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.



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.





Original Post May 2, 2012 at 2.27pm: Chesapeake (CHK): A Trader’s Dream, An Investor’s Nightmare

The story of Chesapeake and its founder, CEO, and Chairman, ceases to amaze even the most hardened market watchers.  Here’s a story of a plush billionaire running a public company worth tens of billions of dollars, and he still couldn’t seem to focus on his main task of running one of the largest natural gas companies in the world.  As far as dramatic character stories go, it doesn’t get much more interesting than this one.

To summarize, Reuters reported 2 weeks ago that McClendon had taken $1.1 billion in personal loans against his stakes in Chesapeake oil and gas wells.  That first barrage of news occurred after the stock had already gradually declined from $25 to near $20, likely on general business fears given the continued weakness in natural gas prices, and caused a break down to $17.5 on big volume.  The stock seemed to base around that level for a week, and news that McClendon was stripped of his Chairman title seemed to signal that the Board of Directors and management was prepared to clean up the mess and move on.

1 YR CHK chart from Bloomberg


After yesterday’s close, just when it finally seemed like the buyers had regained control, pushing the stock briefly above $20, and the news flow had turned incrementally positive, Chesapeake not only reported a big miss on earnings but more importantly, Reuters reported this morning that McClendon had been running a personal hedge fund of $200 million on the side, trading commodities similar to what Chesapeake does as a business.  It’s one thing to take out a loan against your personal assets, as suspicious as that may be, but to compete in the same market as your company, on a personal basis?!?  Our mental alert level just went from cautious to extreme danger.

In this environment of uncertainty, even with the stock at $17, implying a forward P/E of around 8 if the stock can meet next year’s consensus estimates, a naked long stock position seems too risky.  Mr. McClendon is not a run-of-the-mill CEO, but rather the founder who infused his freewheeling style into the culture of the company.  Whatever your long term view of the stock, the leadership saga is likely to continue until McClendon is eventually forced to leave.

Fortunately, options are surprisingly cheap given the recent headlines and volatility in the name.  Our first instinct was to look for a cheap way to play a bounce in the name, but today’s headlines about the personal hedge fund caused us to re-assess that view.  Another serious worry came from the commentary from Chesapeake on the conference call today, as Mr. McClendon seems to digging in for a fight with the media, not willingly stepping down.  Moreover, weak gas prices does create a funding problem, highlighted here by the FT.  Finally, Southeastern, the largest shareholder just came out and indicated its desire to seek talks with Chesapeake management, and the stocks quick 5% pop and then selloff indicates more selling ahead for the next week in CHK.  So here’s our short-term play on this headline-heavy story:

 TRADE: CHK ($17.25) Bought the May 16 Puts for .48

-Break-even on downside is 15.52, lose up to .48 btwn 15.52 and 16 and max loss of .48 above 16 on May 19th expiration.


RATIONALE: Generally we don’t like pressing shorts like this, but this could be the gift that keeps on giving.  I wouldn’t short the stock outright, but to risk 2.5% of the underlying that we get another eye opening revelation before May expiration is a bet I am excited to make.

ALTERNATIVELY if you are long and not sure what to do, but you think there is a decent likelihood that the stock makes back some recent losses, but the worry of further declines outweighs the potential positives, you could consider stock replacement.

LONGS could consider selling their stock and buying the May19th 18 calls for .55 (stock ref 17.06), this will give you reltively cheap upside exposure with defined risk.