Bullish Option Traders LEAP into AGO

04/19/2011 5:00 am EST

Focus: OPTIONS

Andrea Kramer

Associate Editor, Schaeffer's Investment Research, Inc.

Long- and short-term option traders have seldom been more bullish on the bond insurer and are buying LEAPS and shorter-term calls to capitalize. We review their reasoning and the key risk factors.

Assured Guaranty Ltd. (AGO) has been a favorite among call traders in the last few days after Bank of America (BAC) said it settled a mortgage-related lawsuit with the bond insurer for an estimated $1.6 billion.

As a result, the shares of AGO shot up more than 25% higher last week, sparking a flood of fresh bullish bets in the options pits.

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In recent afternoon trading, AGO had already seen roughly 35,000 calls cross the tape—about ten times its expected daily call activity, and more than three times the number of AGO puts exchanged.

Garnering the most attention has been the stock's now-at-the-money January 2012 17.50-strike call, which has seen nearly 7,700 contracts change hands on open interest of fewer than 1,000, hinting at the initiation of new positions. Plus, the majority of the long-term calls have traded at the ask price, suggesting they were bought.

By purchasing the LEAPS (long-term equity anticipation securities) to open, the traders are expecting AGO to remain north of $17.50 over the next several months.

Meanwhile, it seems the shorter-term options crowd is taking a more aggressive stance.

Specifically, the out-of-the-money May 20 call has seen more than 4,500 contracts traded on open interest of just three—again, pointing to newly opened positions. Furthermore, the bulk of the calls—which assumed front-month status after the closing bell Friday—have crossed the tape at the ask price.

By buying to open the 20-strike calls, the investors are rolling the dice on AGO to surmount the $20 level within the next few weeks—a feat accomplished just once in 2011.

Even before the stock’s recent trek higher, options speculators were ramping up their bullish exposure on AGO.

On the International Securities Exchange (ISE), Chicago Board Options Exchange (CBOE), and NASDAQ OMX PHLX (PHLX), the security has racked up a ten-day call/put volume ratio of 10.95, indicating that traders have bought to open almost 11 AGO calls for every put during the past couple weeks.

What's more, this ratio registers in the 79th annual percentile, indicating a greater-than-usual appetite for bullish bets over bearish ones.

As a result of the escalating affinity for optimistic positions, the equity's Schaeffer's put/call open interest ratio (SOIR) now rests at 0.78, which is in the 17th percentile of its annual range.

In other words, near-term options players have rarely been more call-heavy on AGO during the past 12 months.

However, short interest on the stock soared by nearly 9% during the past month and now represents a healthy 6.3% of AGO's total available float. In fact, at the equity's average pace of trading, it would take nearly seven sessions for all of these pessimistic positions to unwind.

Considering the simultaneous influx in both call buying and short selling, at least part of the growing preference for long calls could be attributable to short sellers protecting their bearish bets with bullish options.

Thanks to the recent explosive rally, the shares of AGO are now on pace to finish atop their ten- and 20-week moving averages for the first time since mid-January.

Nevertheless, the stock is still staring up at its 50-month moving average, which is currently docked in the $18.50 neighborhood. This trend line has rejected AGO's monthly advances during the past year and could once again act as a technical headwind for the shares.

From a contrarian standpoint, however, the aforementioned abundance of short interest could actually work to AGO's advantage. As the shares sail higher, a rush to cover among the shorts could translate into additional upside for the security.

By Andrea Kramer, contributor, Schaeffer’s Trading Floor Blog

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