CN Rail’s stock has been in a general downtrend since the beginning of the year closing at $53.30 on Monday February 22, 2010. The actual closing stock price was only up 11 cents but the real action was in CN Rail’s derivatives. Most of the activity was in the March 55 call options which saw 1,188 contracts trade indicating someone’s or some people’s strong bullish sentiment. Open interest before today in that option was only 338 contracts. This compares to only 6 put options with the same expiry that traded today. The option involved is the nearest term option and expires March 19, 2010 indicating evidence of someone’s conviction of a short-term rise in CN Rail’s stock.
Turning to the CDS markets, we also see evidence of some noticeable activity in CN Rail today. After closing last week around 35 basis points, CN Rail was up about 10% to almost 40 basis points. An increase in CDS price levels is usually somewhat of a bearish indicator particularly for the debt of a company as it indicates the perceived credit (or bankruptcy) risk has increased. At less than 50 basis points, CN Rail is perceived to be a very financial strong company so a 10% rise in perceived credit quality in one day is not that common.
A look at the latest CDS volumes in CN Rail up until the week ended February 12, 2010 shows no indication of questionable historical activity. There is a total of $2.2 billion in gross notional value of CDS representing about $373 million in actual money at risk across 449 contracts. Volumes were barely changed from both the previous week and previous month when there was one less and seven less contracts, respectively.
Bullish stock prices and bearish bond prices are not always contradictory. In cases where companies are merged or privatized, such as what happens during a leveraged buy-out, the investors buying a perfectly good company offer a price to public shareholders that is usually higher than the current stock price in order to entice investors to agree to sell their shares to the purchaser. This is bullish for the stock price. In order to finance this purchase, particularly for buy-outs that offer all cash payments, the purchasers of a company often borrow some or all of the money needed to pay these stockholders. The money is also often borrowed in the name of the company being bought out. This is bearish for the bond price. This means the company being bought-out takes on more debt that previously existed in its name before the transaction (debt on the company’s balance sheet increases) and a higher debt load leads to higher interest costs and oftentimes, an increased chance of bankruptcy or default in the event that the company experiences a financial hardship and is unable to meet its new higher interest costs. This transaction effectively replaces stockholders with more bondholders or bank lenders and therefore the event is often bullish (positive) for stockholders but bearish (a negative) for bondholders.
For equity investors looking for trade ideas, options may be a possible vehicle to use. The March 55 calls cost 50 cents to lift the offer as of market close and March 50 puts cost 30 cents to hit the bid. If the same prices hold at Tuesday’s market open then buying the out-of-the-money call option or selling the out-of-the-money put option may be a good way to setup a trade based on indicators from the derivative markets. If you sell the put, you are still going long the company because you are agreeing to purchase the stock only if its price falls to $50 or below. Based on Monday’s closing price, CN Rail would need to fall about 6.8% lower before you could lose money on that trade and if the stock never falls that low then your gain is capped at 30 cents per contract. On the other hand, buying the call means you only lose a maximum of 50 cents per contract if the stock does not reach $55 by March 19 but leaves unlimited potential upside if CN Rail’s stock rises above that level.
Disclosure: long all stocks