Options Update: Chesapeake Energy Calls Active on Takeover Speculation

Unsubstantiated takeover rumors and the perceived benefits of an Obama presidency for natural-gas providers have sent the shares of Chesapeake Energy
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rocketing higher in afternoon trading.

According to a Reuters interview, an analyst with vFinance Investments stated that because of the stock’s plunge from its highs near $74 in July, “Chesapeake is now considered to be a takeover candidate.”

Meanwhile, Chesapeake CEO Aubrey McClendon told analysts last week that an Obama administration “…will be very favorably inclined to try to do something about introducing natural gas into the transportation network in a more aggressive way than what has happened in the past four to eight years.”

As you might expect, CHK’s options pits are buzzing with activity. In today’s trading, more than 102,000 CHK calls have crossed the tape, outpacing the stock’s average daily call volume by a ratio of more than 5-to-1 and placing the shares on our Intraday Volume Explosion List. However, it was the heavy activity at the November 30 call that caught my eye this afternoon.

Chesapeake Energy option volume details

The Anatomy of a Chesapeake Energy Call Position

Diving into the activity, I found that more than 14,000 calls have crossed the tape at CHK’s November 30 strike. Most of the volume was focused in blocks of 100 or more contracts, with quite a few 500-plus block trading near the 10 o’clock hour. Incidentally, 10:00 a.m. Eastern time appears to be the time when the takeover rumors began spreading in earnest across Wall Street, as the intraday chart below indicates.

Intraday chart of Chesapeake Energy for November 5, 2008

Looking closer at today’s volume, it would seem that the vast majority of today’s activity changed hands at the ask price. Combine this data with the fact that volume at the November 30 strike has easily exceeded open interest at this front-month strike, and today’s activity could well be of the buy-to-open persuasion. For today’s trading example, a block of 500 CHK November 30 calls traded at 10:24 a.m. Eastern time, changing hands at the ask price of $1.00. The total outlay for this position would be $50,000 – ($1.00 * 100)*500 = $50,000. For this trade to reach breakeven, CHK would need to rally about 35% from yesterday’s close of $22.95 per share before the options expire on November 21. The maximum loss on this position is limited to the initial investment of $50,000.

By entering this trade, the investor is indicating that he expects CHK to rally sharply before November 21. The shares have a good head start, with today’s jump of more than 7%, but let’s see if the stock’s technical or sentiment backdrops provide any additional drivers for this trade.

Getting Technical

Technically speaking, there are some significant hurdles that must be overcome before a November 30 call can reach profitability. The most daunting may be technical resistance in the 25-26 region. CHK has been trapped below this area since early October, with the shares trending sideways along support at the 16 level. The equity’s 10-day and 20-day moving averages could help with this situation, however, as they recently completed a bullish cross and could help pressure CHK higher over the short-term.

Daily chart of Chesapeake Energy since September 2008 with 10-day and 20-day moving averages

Another potential hurdle for CHK lies at the 30 level, site of the aforementioned November 30 call. This round-number region has long been a support/resistance level for the shares, and could prove considerably difficult to surmount – especially before November 21 – in the absence of an actual takeover bid. Furthermore, CHK’s declining 10-week moving average has taken up residence in the area. The equity has not closed a week above this trendline since the week of July 11. The shares would need to topple this repressive moving average in order for a November 30 call to reach breakeven.

Weekly chart of Chesapeake Energy since July 2008 with 10-week and 20-week moving averages

The Sentiment Drivers

Unfortunately for CHK contrarian investors, the stock’s sentiment backdrop provides very little in the way of a catalyst for the type of sharp move needed to push a November 30 call into the money. Specifically, most CHK investors appear to have already placed their bullish bets, sapping any potential buying strength for the equity that could move in from the sidelines. In the options pits, the security’s Schaeffer’s put/call open interest ratio (SOIR) of 0.57 indicates that calls nearly double puts among near-term options. This ratio also ranks below 69% of all those taken during the past year.

Elsewhere, Zacks.com reports that 17 of the 22 analysts following CHK already rate the shares a “buy” or better. This configuration not only decreases the chances of upgrades for the stock, but also leaves CHK open to valuation downgrades if brokerage firms feel that the equity has run too far too fast on rumors of a potential buyout. What’s more, price-target cuts could also impact the shares, as Thomson Financial places CHK’s average 12-month price target at $47.45 per share – a 106% premium to the security’s close on Tuesday.

The lone potential driver for the stock resides with the short-selling community. These bears are beginning to cover their bets, as CHK short interest declined by nearly 6% during the most recent reporting period. Still, more than 6% of the stock’s float is sold short, and could provide additional fuel for a short-covering rally.

Sentiment indicators for Dendreon

The Verdict?

While the prospects for CHK look moderately bullish over the long-term given the potential for improved natural-gas market conditions under an Obama presidency, the short-term outlook is not extremely favorable. Resistance in the 25-26 region, and long-term resistance at the 30 level could severely hamper returns on a November 30 call. I would not be adverse to a December or January 2009 30 call, but this front-month speculation appears to hinge solely on the prospects of a takeover offer that has yet to materialize.

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