Options Update: Call Volume Swells on Canadian Pacific Railway Ltd.

Shares of Canadian Pacific Railway Ltd.
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have plunged nearly 11% so far today, joining the rest of the market in a broad-based sell-off. The stock has struggled so far in 2008, dropping more than 31%, and analysts are beginning to take notice – for better or worse. During the past week, CP saw its price target cut to C$77 from C$80 at UBS on October 9, while CIBC slashed its price target to C$61 from C$71 yesterday. Muddying the waters from a sentiment perspective, Stifel upgraded the shares to “buy” from “hold” on Tuesday morning.

The Stifel upgrade prompted an early-morning spike in CP to near the 50 level, proving that the shares of this railroad company are just as vulnerable to volatility as the rest of the market. It could very well have been this show of volatility that prompted today’s unusual options activity on the equity. So far, more than 4,000 calls have changed hands on CP, outnumbering the stock’s average daily call volume by a factor of 18 and placing the equity on today’s Intraday Volume Explosion List. Nearly all of this volume traded in 2 blocks at CP’s December 45 and December 55 calls, catching my eye this afternoon.

Canadian Pacific Railway Ltd. option volume details

The Anatomy of a Canadian Pacific Railway Call-Spread Position

Diving headlong into the activity, it would appear that we are looking at a bull-call spread on CP today. The 2,000 calls that changed hands at the stock’s December 45 strike appear to have been purchased for $2.65, creating a debit of $530,000 — ($2.65 * 100)*2,000 = $530,000. Simultaneously, the trader sold 2,000 December 55 calls for a credit of $110,000 — ($0.55 * 100)*2,000 = $110,000. The total debit for this moderately bullish position arrives at $420,000 — ($530,000 – $110,000 = $420,000).

For this trade to reach breakeven, CP would need to rally about 10% to $42.90 per share from its current trading range near $39. We arrive at this by subtracting the difference ($2.65 – $0.55 = $2.10) between the purchased December 45 call ($2.65) and the sold December 55 call ($0.55) from the purchased 45 call ($45 – $2.10 = $49.90). As you can see, the trader has lowered his breakeven target by selling the December 55 call. The maximum loss on this position is the initial investment of $420,000.

By entering this trade, the investor is indicating that he is moderately bullish on CP. The trade reaches its maximum profit as the stock nears the sold December 55 call, with gains clearly capped at just below the 55 level. Should CP rally above the 55 strike, (say, to $56 per share) both options would be in the money, and the sold position could be exercised. In this case, the trader can exercise the December 45 call, buying CP shares at $45, and then selling those shares for $55 to cover the sold December 55 call. The result is a profit of $5 per share, with the trader missing out on any points the stock rallies above the 55 strike (in this case, $1 per share).

If the trader is looking to take advantage of a muted rebound in the shares, then a bull-call spread is a nice way to offset the entry costs while capitalizing on such a rally. That said, let’s see exactly where CP stands from a technical and sentiment standpoint.

Getting Technical

Technically speaking, the outlook for CP shares is growing more grim by the minute. Amid today’s broad-market selling pressure, the stock has blown past potential support at the round-number 40 level. Furthermore, yesterday’s rejection at the security’s declining 20-day moving average and the round-number 50 level do not bode well for any sizeable gains for such an option position. Complicating matters further, CP is now trading back below resistance at its 10-day moving average, which the shares have not closed a session above since September 26.

Daily chart of Canadian Pacific Railway since June 2008 with 10-day and 20-day moving averages

The Sentiment Drivers

The stock’s sentiment backdrop is mixed, and offers little in the way of support for a bull-call spread. In the options pits, CP’s Schaeffer’s put/call open interest ratio (SOIR) of 0.84 ranks in the 69th percentile of its annual range, indicating that speculative traders are moderately bearish on the equity. However, given the stock’s poor price action this year, there is room for this ratio to rise further through the addition of put open interest. Such a development could increase selling pressure on CP, thus working against a call position on the shares.

Alternately, Wall Street analysts are heavily bearish on the security. According to Zacks.com, 9 of the 10 brokerage firms covering CP rate the shares a “hold” or worse. As mentioned above, we have already seen one brokerage firm come out and upgrade the security. Should more analysts follow suit, it could prove to be a boon for CP. However, Thomson Financial reports that the average 12-month price target for the shares rests at $71.09 per share – an 82% premium to CP’s current price near $39 per share. Despite yesterday’s upgrade, the trend among brokerage firms for CP is leaning more toward price-target cuts.

Sentiment indicators for Canadian Pacific Railway

The Verdict?

With several layers of technical resistance between CP and the 45 level, a bull-call spread centered on the December 45 strike looks questionable at best. The lone benefit of the position is that the company is slated to release its third-quarter earnings report on October 28. Wall Street is currently looking for a profit of $1.07 per share from CP, a drop from the $1.17 per share earned in the same quarter last year. If the company can impress investors with this fundamental report, we could see a bounce in CP shares. Of course, given today’s sharp decline, even a surge following the report may not be enough to overcome an extended decline in the stock between now and October 28.

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.