Options Update: Chesapeake Energy Calls Popular on BP Buyout Speculation

Speculation is swirling around Chesapeake Energy
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and British oil giant BP PLC
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in today’s trading. Shares of CHK have jumped more than 5%, while BP is up more than 4% following rumors that the latter could be planning a bid for Chesapeake.Near midday, however, a BP spokesperson said that “We never comment on market rumors.”

BP’s comments have failed to stem speculation in the options pits today, as more than 41,000 CHK calls have traded so far, placing the stock on our Intraday Volume Explosion List. The activity runs counter to the current mood among options speculators, as CHK’s Schaeffer’s put/call open interest ratio (SOIR) of 2.20 indicates that puts more than double calls among near-term options. Furthermore, this ratio ranks above 89% of all those taken during the past year.

Additionally, put buying relative to call buying on the International Securities Exchange (ISE) and the Chicago Board Options Exchange (CBOE) is near an annual peak. The current ISE/CBOE of 1.15 rests above 99% of all those taken during the past year, underscoring the attention that speculative options traders are paying to a potential decline in CHK shares.

That said, today’s volume highlights more bullish aspirations from the options crowd. Specifically, a majority of call contracts that changed hands on CHK’s February 20 strike this morning crossed at the ask price, suggesting that these options were bought to open. Combining this “ask” activity with the fact that volume at this front-month option has far exceeded open interest serves to strengthen the argument for bullish activity.

Chesapeake Energy option volume details

The Anatomy of a Chesapeake Energy Call Position

Digging into this call activity, I noticed that a block of 1,442 February 20 calls traded at the ask price of $0.45 at 10:02 a.m. Eastern time. The total outlay for this position totals $64,890 — ($0.45 * 100)*1,442 = $64,890. For this trade to reach breakeven, CHK would need to rally about 37% to $20.45 per share from the stock’s Friday close of $14.90 before the options expire on Feb. 20. The maximum loss on this position is limited to the initial investment of $64,890.

By entering this trade, the investor is indicating that he expects CHK to rally sharply during the next several weeks, potentially due to a bid from BP if today’s speculation holds water. The position has started on the right foot, with the shares up about 5% at last check. That said, let’s see if the stock’s technical or sentiment backdrops provide any additional drivers for this trade.

Getting Technical

From a technical perspective, the stock has dropped more than 58% during the past 52 weeks, edging out the S&P 500 Index’s (SPX) loss of more than 37% for the same time frame. The stock continues to struggle with overhead resistance at its 10-week moving average, having not closed a week above this trendline since July 2008. Furthermore, short-term resistance appears to be building at the 16 level, which is home to CHK’s 20-day trendline. Clearly, this backdrop does not favor a February 20 call, and it seems much more likely that today’s options traders are taking a chance on the possibility that BP will officially launch a bid for CHK.

Weekly chart of Chesapeake Energy since July 2008 with 10-week moving average

The Sentiment Drivers

Sentiment toward CHK also points toward an extended downtrend for the shares. Wall Street analysts are firmly entrenched in the bulls’ camp, as 15 of the 21 brokerage firms following the equity rate it a “buy” or better, according to Zacks. Furthermore, Thomson Financial reports that the average 12-month price target for CHK rests at $31.08 per share – a 108% premium to the stock’s close on Friday. Any downgrades or price-target cuts could send CHK sharply lower should the BP speculation prove false.

Meanwhile, short interest accounts for about 6.5% of the stock’s total float. While this heavy accumulation of short positions could provide fuel for a short-covering rally, CHK’s recent technical performance has done little to put fear into these bears. To the contrary, the number of CHK shares sold short rose by 15% during the most recent reporting period; should this trend gain momentum, the resulting selling pressure could send CHK steadily lower as a result.

Sentiment indicators for Chesapeake Energy

The Verdict?

Prior to this morning’s buyout of Wyeth by Pfizer, I would have advised taking the opposite side of today’s heavy call volume. But this merger and acquisition blockbuster has given me pause due to the fact that Pfizer was able to acquire the necessary financing to proceed with the deal. That said, CHK has been down this road before, with obvious results. Those with enough conviction, or nerve, might want to consider a February 17.50 put to take advantage of a retreat in the shares should the BP speculation fade into the background.

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