Capstead Sees Huge Bullish Options Surge — Get On Board

Unusual call activity has us looking for upside here

   

Capstead Mortgage (CMO) has been among the laggards in the mortgage REIT field, as jitters surrounding the possible slowing of the Federal Reserve’s open market operations and lifting of benchmark rates have led many to fear that current returns will decline. Sellers may have unwittingly created an opportunity for savvy investors to buy into this fund at a discount; Capstead is exclusively invested in government guaranteed adjustable-rate mortgage securities, which bear little to no default or interest rate adjustment risk.

Based on the macroeconomic outlook, it seems sensible that related funds (and the underlying assets held by these funds) would be at risk in the near future. As stated above, Capstead seems to be a victim of a sector-wide selloff resulting from the belief that mortgage interest rates will soon begin to rise. CMO has lost value at a lower rate than those mortgage funds with fixed-rate aspects to their holdings. Because of CMO’s defensive setup, the stock is far less volatile than its peers, which lowers its appeal for near-term and retail investors.

The company essentially guarantees a return on investment. CMO currently boasts a five-year compound annual total return of 12.4%, according to David White for SeekingAlpha.com, and pays a 9.6% dividend.

So it should be a positive sign for the stock that a large trader purchased 5,900 July 12.50 calls during Monday’s trading session. At the time the trade was made, open interest in CMO was a mere 137 contracts. This is a bullish setup and, though Capstead’s current predicament may be the result of more complicated factors than a simple misreading by the market, the purchase may produce a level of interest in the stock that will help it to return to a more appropriate valuation.

Analyzing unusual order flow gives traders a window into what the positions that large institutional players have. The majority of unusual option activity can be traced back to hedge funds, mutual funds, and other large institutions. Knowing where these institutions are placing their bets can be hugely advantageous for any trader. These institutions have informational and technological advantages that the average trader doesn’t have, and the amount of time and analysis that goes into every one of their trades is substantial.

We define unusual option activity as large block trades that represent a large percentage of daily option volume. The block trade is considered “unusual” if the option volume is above the average daily volume over the past 22 days. At KeeneOnTheMarket.com we scan and analyze order flow from all of the major options exchanges in order to identify any unusual option activity.

But order flow can be deceiving. One might logically think that a large-block buyer of calls is bullish on the underlying. This is not always the case. Remember that lots of participants in the equity options market are hedgers — long calls are a hedge against short stock, and long puts are a hedge against long stock. With this in mind we have developed a seven-step trading plan that helps filter out unusual option activity that will not provide actionable trade setups. It is by using this plan that we are able to identify the most significant unusual options activity trades every day.

And this plan reveals that the CMO setup should be a profitable one.

Trade: I bought the CMO Nov 12.50 calls for $0.50, risking $50 per lot. Reward is potentially unlimited, and breakeven is at $13.

Greeks of this trade:

  • Delta: Long
  • Gamma: Long
  • Theta: Short
  • Vega: Long

At the time of publication, Keene was long the CMO Nov 12.50 calls for $0.50.


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