Options Update: Struggling AIG Sees Heavy Call and Put Volume
The first media indications of trouble with American International Group
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PowerRating) surfaced in a New York Times article on Friday, with the Times noting that the insurer “has reported some of the biggest losses in the spreading credit crisis.”
The situation worsened yesterday, when AIG announced that it had loaned itself $20 billion and requested additional government aid to shore up its finances. Fast forward to this morning, the shares are now being pressured by several credit-rating downgrades from the likes of A.M. Best, Moody’s, Fitch, and Standard & Poors.
The deluge of negative attention has pressured AIG shares more than 82% lower since Thursday, and options traders have been quick to pounce on the beleaguered insurance giant. According to data from the International Securities Exchange (ISE), some 35,651 puts were bought to open yesterday on its exchange, compared to 33,069 calls purchased. Meanwhile, combined put/call volume from the ISE and the CBOE indicate that 73,861 calls were bought to open, compared to 63,202 puts.
The mixed option activity has extended into today’s trading, with heavy call and put volume changing hands in what appears to be buying activity. Specifically, more than 87,000 AIG puts have traded so far on the session, versus 135,959 call contracts. The excessive volume has placed both AIG puts and calls near the top of our Intraday Volume Explosion List, but there were 2 particular contracts that caught my eye today: the September 5 call and the October 2.50 put.
Looking at the chart above, you can see that the vast majority of today’s volume changed hands at the ask price on both the AIG September 5 call and the October 2.50 put. This ask activity, combined with the fact that volume on both contracts has easily outstripped open interest, suggests that traders are buying (to open) AIG calls and puts. For today’s call-buying example, I’ll be using the combined block of 1,000 contracts that traded at 10:53 a.m. Eastern time – all of which traded at the same time on the same exchange, hinting that they could be part of a larger position. On the put side, there was a block of 4,000 contracts that crossed the tape at 10:54 a.m. Eastern that we will be focusing on today.
The Anatomy of an AIG Put Position
Digging into today’s put-buying example, the hypothetical trader purchased 4,000 AIG October 2.5 puts for $1.40, or a total outlay of $560,000 — ($1.40 * 100)*4,000 = $560,000. The timing for this trade was impeccable, with the shares trading at $3.28 versus breakeven at $3.60. We arrive at breakeven for the trade by subtracting the cost of the option ($1.40) from the strike of the purchased 5 put ($5 – $1.40 = $3.60). The total loss for this position is limited to the initial investment of $560,000. Given the data above, the position is already up about 11%.
The Anatomy of an AIG Call Position
Turning our attention to the AIG September 5 call, the hypothetical trader purchased 1,000 of these options for a total outlay of $95,000 — ($0.95 * 100)*1,000 = $95,000. For this trade to reach breakeven, AIG would need to rally about 90% to $5.95 per share. We arrive at this by adding the cost of the option ($0.95) to the strike of the purchased 5 call ($0.95 + $5 = $5.95). The total loss for this position is limited to the initial investment of $95,000.
The latter trade is highly speculative, considering that September options expire at the end of the week. Both trades are extremely risky at this point, however. The put position is banking on an extended decline in the shares – presumably due to the potential failure of AIG to acquire adequate funding to stay afloat. Meanwhile, the call trade is clearly a bet that the Fed will not let the company follow in the footsteps of Lehman Brothers. But, while both trades revolve around hypothetical situations, let’s see if the stock’s sentiment or technical backdrops provides any additional backdrop for the situation.
Getting Technical
Aside from a potential bounce from an oversold situation, there is very little technical support for AIG. The stock has plunged more than 91% on a year-to-date basis, declining steadily under resistance at its 10-week and 20-week moving averages until the end of last week. The shares have since accelerated to the downside, and are now trading in territory not seen since October 1985. In late 1985, AIG found technical support at the 3 level, but there is no guarantee that the current situation can be mitigated by such stale technical support.
The Sentiment Drivers
The sentiment backdrop for AIG offers little in the way of encouragement for call traders. The stock’s Schaeffer’s put/call open interest ratio (SOIR) of 1.12 ranks near the mid-point if its annual range, suggesting complacency from the options crowd. Furthermore, today’s preference for calls over puts and the ISE/CBOE call volume from yesterday hints that optimism for a rebound is potentially on the rise. This rising bullish sentiment on a struggling equity has negative implications from a contrarian standpoint.
Meanwhile, there is ample room for additional downgrades from the brokerage bunch. According to Zacks.com, 5 of the 11 analysts following AIG still rate the shares a “buy” or better. Downgrades from this optimistic group of analysts could provide additional selling pressure for AIG.
The Verdict?
Personally, I wouldn’t touch AIG options with a 10-foot pole right now. The stock’s Schaeffer’s Volatility Index (SVI) is currently through the roof, arriving higher than nearly all such readings taken during the past year. What this means is that AIG options are extremely expensive, as traders price in the excessive volatility in the market. In fact, implieds on the September 5 call were at about 835% as of last night’s close, compared to the 1-month historical volatility of 350%. If you are an adrenaline junkie, then an AIG option play might work in your favor, but I’m sitting this one out.
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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.