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Energy ETF Options Portend Tough Times Ahead, but Smooth Sailing to Follow

Posted on the 13 May 2011 by Phil's Stock World @philstockworld

 Today’s tickers: XLE, LIZ, NE & CBST

XLE - Energy Select Sector SPDR Fund – Two massive transactions in XLE options today suggest nearer-term pessimism on the energy sector and longer-term optimism. Shares in the fund started the session in positive territory, but the rally proved to be short-lived as shares are currently trading 0.60% lower on the day at $73.72 just before 12:50pm. The XLE, an exchange-traded fund that corresponds to the performance of the Energy Select Sector of the S&P 500 Index, jumped to the top of our ‘most active by options volume’ market scanner this morning after a huge bull call spread was purchased outright in the September contract. The transaction is a profitable one if shares in the XLE top recent highs to trade at levels not seen since mid-2008. The options player purchased 52,750 calls at the September $79 strike for a premium of $2.23 each, and sold the same number of calls up at the September $90 strike at a premium of $0.28 apiece. Net premium paid to initiate the spread amounts to $1.95 per contract, a price tag of more than $10.28 million. Profits are available to the trader should shares in the fund surge 9.8% over the current price of $73.72 to exceed the effective breakeven point at $80.95 by September expiration. Maximum potential profits implied by the spread’s parameters amount to $9.05 per contract if the price of the underlying fund jumps 22.1% in the next four months to trade above $90.00 at expiration. Meanwhile, a large put spread purchased in the nearer-term June ‘30 expiry suggests a less rosy outlook on the energy sector over the next seven weeks. The spread was likely purchased by the investor, although direction in this case is more difficult to determine as both legs of the transaction traded to the middle of the market. The pessimistic player appears to have purchased 33,330 in-the-money puts at the June $75 strike for a premium of $3.27 each, against the sale of the same number of put options at the lower June $65 strike at a premium of $0.52 a-pop. The net cost of the spread amounts to $2.75 per contract, thus yielding profits below a breakeven share price of $72.25, with maximum potential profits of $7.25 per contract available in the event that XLE shares plunge 11.8% to trade below $65.00 at expiration in June. The nearer-term position suggests the descent from recent multi-year highs is likely to continue into the summer, while the longer-term bullish play prophesies significant gains in the energy sector come fall.

LIZ - Liz Claiborne, Inc. – A short straddle on the owner of a portfolio of premium retail brands including Kate Spade, Juicy Couture and Lucky Brand suggest one strategist expects shares in Liz Claiborne to remain range-bound through July expiration. Shares in LIZ are currently down 1.85% to stand at $6.36 as of 11:45am in New York. The investors sold 5,000 in-the-money put options and sold 5,000 calls at the July $7.0 strike to pocket gross premium of $1.35 per contract on the transaction. The trader keeps the full amount of premium if shares in Liz Claiborne settle at $7.00 at July expiration. Profits on the straddle erode as shares shift in either direction away from the central strike price, such that losses start to accumulate if the price of the underlying exceeds the upper breakeven price of $8.35, or should the stock slip beneath the lower breakeven point at $5.65. LIZ’s shares have not topped $8.35 since May 2010, but have closed below $5.65 as recently as April 19, 2011. The best-case scenario on a short straddle is that shares settle at the strike price, but perhaps this investor is willing to get long the stock at $5.65 if the puts are exercised against him at expiration. Unlimited losses to the upside suggest the trader sees little chance for a sharp rally in the stock above $8.35 over the next few months. As with any short options position, the investor will benefit from time decay of the option premium as well as subsiding levels of options implied volatility on the stock. The trader could decide to buy back the straddle at an advantageous price if the opportunity presents itself at some point ahead of expiration in July.

NE - Noble Corp. – The offshore drilling contractor for the oil and gas industry attracted bullish players during the first half of the trading session with shares rallying 2.4% to an intraday high of $40.52. The stock has since pared gains and turned negative, trading 0.60% lower on the day at $39.34 as of 12:15pm. Call options in the front month received the most attention from investors populating the stock today. Traders exchanged more than 5,100 calls at the May $40 strike on previously existing open interest of 1,805 contracts. Not all of the calls were purchased, but it does look like buyers of the options are at a slight majority versus those selling the calls. Investors positioning for a near-term rally picked up approximately 2,500 of the calls for an average premium of $0.60 each. Trading traffic was less mixed up at the May $41 strike where some 4,700 call options changed hands on open interest of 1,523 contracts. Most of these calls were purchased for an average premium of $0.30 a-pop. Call buyers profit if shares in Noble Corp. surge 5.0% over the current price of $39.34 to trade above the average breakeven point at $41.30 by expiration next week. Noble Corp.’s analyst day is scheduled for Tuesday of next week.

CBST - Cubist Pharmaceuticals, Inc. – Shares in the biotechnology company are down 1.3% at $34.75 this afternoon, but according to one options player the stock is likely to rise into 2012. It looks like the trader has dabbled in Cubist Pharmaceuticals call options in the past, and is today taking profits off the table as well as extending bullish sentiment on the stock. Open interest in call options at the Jan. 2012 $35 strike suggest 4,000 calls were picked up for a premium of $2.25 each on April 7. Another 2,000 calls were purchased at that strike at a premium of $2.75 apiece the following week on April 15. In both cases, it looks like the calls were matched with the sale of put options at the Jan. 2012 $25 strike, with 4,000 puts sold at a premium of $1.70 per contract on April 7, and 2,000 puts sold at $1.40 each the following week. During this time period, shares in CBST rallied 43.2% from $21.44 on March 4 to $30.71 by April 7. By April 15, the stock was up 51.0% over its March low of $21.44 to trade as high as $32.33. The bullish player missed out on the initial jump up in the biopharmaceutical company’s shares, but even so was able to catch much of the rally by partially financing the purchase of calls with the sale of put options. It looks like the trader sold 6,000 calls at the Jan. 2012 $35 strike for a premium of $4.60 each today, resulting in substantial gains over the average net premium of $0.81 paid to originally get long the calls last month. Finally, the trader positioned for continued bullish movement in the price of the underlying stock by purchasing 6,000 calls up at the Jan. 2012 $40 strike for a premium of $2.80 each. Profits on the fresh long-call position are available to the trader at expiration if the price of the underlying stock rallies 23.2% over the current price of $34.75 to exceed the effective breakeven point at $42.80.

Andrew Wilkinson
Senior Market Analyst
ibanalyst@interactivebrokers.com

Caitlin Duffy
Equity Options Analyst


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