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March call-holder gets wary after Delta-Northwest talks hit snag

Today’s tickers: NWA, NRG, XLNX, CSCO, PHM, TOL, NOC, FNM, FRE, XLB, ADSK, JEF, NSM

NWA – Shares in Northwest Airlines skidded nearly 7% to $14.92 in afternoon trading on news of a snag in its merger talks with Delta. The road bump concerns talks with both carriers’ pilots’ unions over job seniority after the integration of the airlines. The development looks to have spurred at least one major holder of those infamous March calls (“pegged” by option traders since last fall as a likely timeline for airline consolidation) to sell out at the 17.50 strike for 25 cents – a substantial discount from yesterday’s levels – and possibly roll the position into a more moderate call-spread position in the June contract between strikes 15 and 17.50. If this is indeed a bullish trade amended into a long call spread, as we suspect, the trader would have bought the June 15 calls for $2.65 while selling the 17.50 calls for $1.60, opening the transaction with a $1.05 debit that renders profit for the buyer if Northwest shares reclaim the $16.05 mark – but selling the upper strike means capping the upside. The rollover of this single position sent option volume in Northwest to 36 times the normal level.

NRG – Earnings are due out from diversified energy company NRG Energy tomorrow, and it’s in anticipation of those earnings and a 2% decline in share price to $40.52 that we find options trading at 53 times the normal level. While NRG topped the Wall Street Journal’s list of stocks bought on weakness today, it looks like option traders took the opportunity to sell off the equivalent of nearly all the open interest in March 40 calls. These were sold for about $2.20 apiece as premiums came off by about 25% in value due to the share price decline. Most of the open interest here was opened at $2.80 on January 8, so closing with a sale now would yield a loss. We also observed put-buying in the January 2010 contract at $1.15 – a striking move in an out-of-the-money put with plenty of time value but a tiny delta suggesting just a 7% chance that NRG shares will lose half their value over the next 2 years.

CSCO – Shares in Cisco bounced 3% to $24.81 following “buy” recommendations of the company’s stock by Wells Fargo and Citigroup. The move sent option volume to nearly 113,000 lots in afternoon trading, making it one of the most active option families on our platform. It looks here as though option traders are taking advantage of the gap in implied volatility below the historic reading – 27% implied versus a historic degree of volatility of nearly 54% – to long the March 24/25 strangle. The combined price of this premium at 95 cents becomes profitable for the buyer with a break below $23.05 or above $25.95 – a cheap bet for resounding price action either way out of Cisco.

XLNX – A UBS upgrade of silicon device maker Xilinx earlier today sent shares 1.2% higher to $22.94. Its options are trading at circuit-breaker-pace today, trading at more than 18 times the normal level – a volume measuring up to more than half its open interest. The action here appears contrarian, with put-spread activity in the April contract between strikes 20 and 22.50. In this case, the trader would have sold the lower-strike puts for 20 cents apiece to partially fund the purchase of 22.50 puts for 84 cents, implying a pull back in prices heading into the month of April. While Xilinx shares have recovered nicely from the $18.87 low set back on January 16, the current $23 share price is roughly equal to its average price of the past 6 months.

PHM – It used to be that any grain of sober truth out of the homebuilders occasioned a virtual landslide in share prices and a dive into put protection by option traders. Yet some of the action we’re seeing in leading homebuilders seems to contradict the song-and-dance that has prevailed lo these many months. Yesterday, Pulte Homes, the country’s third-biggest homebuilder, said in an SEC filing that it expects its pretax loss positions to persist through 2008. A glass-half-full perspective was expressed the same day on CNBC, where billionaire real-estate investor Sam Zell projected the beginning for a recovery in housing this spring. Shares in Pulte Homes were up 1.7% to $15.76 this afternoon, with the jump in share price accompanied by a surge in option volume to 4 and a half times the normal level. Heavy buying interest in March 15 calls at around $1.60 is a good indication that option traders aren’t expecting prices to scamper to the downside over the next few weeks. Further out, the action looks positively, guardedly bullish. For evidence of that, consider the action in Pulte Homes in the October contract, where it looks as though a trader felt comfortable enough to short the October 7.50 puts for 80 cents on a volume of 5,000 lots, while putting on a collar at the 15 put and 25 call in order to protect anticipated gains in a long position in Pulte stock. The long put position at $15 is put on to shield gains in the stock over the coming months, while the accompanying sale of the covered call means the trader is willing to part with Pulte at the price of the call strike.

TOL – An identical strategy was observed in options of Toll Brothers, the country’s largest luxury home builder, whose shares climbed 2.7% to $23.76. Earlier today the company reported a $96 million Q1 loss, but drew positive feedback from analysts on its strong balance sheet and free cash flow. In addition to heavy traffic at the March 25 calls – which attracted buyers and sellers as the prices of the position gained 50% in value on this 4th consecutive day of gains for the stock – it appears that the collar strategy was deployed in the September contract. Here, the trader bought the protective 22.50 put for $3.20 in conjunction with the sale of a covered call at the 35 strike for 65 cents. This upper strike – the price at which the Toll Brothers stockholder would be willing to divest the shares – is fully 12% above the standing 52-week high in Toll Brothers. It is worth noting in the case of both Toll Brothers and Pulte Homes that the prevailing attitude remains largely defensive, with 1.4 times as many open positions as calls in both tickers.

NOC – Pressure has been building for a break above the standing 52-week high in the country’s third-largest defense company, Northrup Grumman. News is due any day now out of the Pentagon as to a decision on a $40 billion contract to supply next-generation aerial refueling tankers for the U.S. Air Force, and the choice is down to Boeing and Northrup Grumman. Last week our market scanners seized upon heavy buying in April 85 calls in the company, but today, its shares stand 1.5% higher at $80.75 and once again, we’re seeing outsized movement in its options with a quadrupling in volume compared to normal levels. Implied volatility at 21.8% actually comes in below the historic 26.5% reading – an indication that current premiums are factoring in less price risk to Northrup Grumman shares than they have shown historically. A trader may have taken advantage of this lower-volatility environment for premiums by going long the March 80 straddle for about $4.00. This position generates profit for the trader with a break to the downside below $76 or up above $84 – within spitting distance of the $84.84 52-week high. The fact that calls one strike higher at the 85 mark are also being bought heavily on volume twice the open interest suggests that this risk is to the upside.

FNM –Shares in Fannie Mae staged a dramatic reversal after trading sharply lower in the premarket on back of its $3.6 billion reported loss for Q4. The reverse came around 10:40 after news emerged of a statement by the Office of Federal Housing Enterprise Oversight that Fannie Mae and its fellow home loan provider Freddie Mac would see their portfolio limits removed on Friday. With shares now flat at $27.02, a huge chunk of the active volume in Fannie Mae options appears concentrated in March 30 calls, which are trading to buyers and sellers. The $1.85 premium on this position is 77% higher than was the case yesterday as traders bid up the price on back of Fannie Mae’s chameleonic share price action.

FRE – Shares in Freddie Mac followed Fannie higher after the OFHEO report, and with shares up 1.6% to $25.67 we’re observing 120,000-plus options change hands in afternoon trading. March 20 and 22.50 puts are still finding buyers as premiums have come off about 40%. Calls at the April 25 mark have also been bought heavily at around $3.30, a position which first becomes profitable for the buyer with a break past $28.30.

XLB – Materials Select Sector SPDR – Intriguing contrarian action in the commodity-rich ETF, whose components include Freeport-McMoRan Copper, Dow Chemical, Newmont Mining and Monsanto. Shares are down .33% – reversing the early gains seen throughout the commodity complex on back of the weak dollar. What’s more interesting is that the upside move has elicited a rush among traders to buy March puts at strikes of 40 and 41. While the current price of the underlying share – $42.80 – is about a dollar off its 52-week high, today’s action shows some traders bracing for a retreat in its value over the coming weeks and want to protect gains on back of this most recent bout of dollar softness. The fact that 4 times as many put positions as calls are held in this ETF suggests that puts are a popular hedge among traders with long positions elsewhere in the sector.

ADSK – Autodesk – An earnings miss due to slowing order flow and more overhead was costly for the maker of AutoCAD drafting software. Shares dropped 15% to $33.14 in afternoon trading, while option volume shows a 7-fold increase from normal levels. It appears that option traders called this release correctly, accumulating positions yesterday in March 37.50 puts for $1.10, which explains the wave of profit taking we’re seeing today as the position more than tripled in value to $1.10.

JEF –Jefferies Group Inc. – Early morning option activity in this full-service investment bank showed an early 23% spike in implied volatility to 56% (that level has since come off slightly), while the heaviest volume in call buying in 10 months sent overall option volume to almost 10 times the normal level. Shares, meanwhile, are 3% higher at $19.25. We’re hearing incipient reports of takeover chatter, which could explain the interest in March 20 and 22.50 calls, which are being bought heavily at prices of 55 cents and 60 cents respectively. A break of $20 would restore Jefferies to early-February levels, breached to the downside after a respectable late-January recovery. Jefferies shares are down nearly 18% for the year to date.

NSM – National Semiconductor – One week ahead of earnings, shares of National Semiconductor are trading .46% higher at $17.65 and its options are trading at 3 times the normal level. Given today’s upside share price movement we were particularly piqued to observe heavy buying interest in March 17.50 puts for 80 cents apiece. The volume suggests that NSM shares may plumb the 52-week low of $16.74 in connection with earnings. Shares in NSM are down 22.7% for the year to date, staging a more or less uninterrupted decline that started on December 7. Option traders, however, hold twice as many call positions as puts.


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