Trade of the Day: Ambac Financial (NASDAQ:AMBC)

Ambac Financial (NASDAQ:AMBC) was an interesting idea last week. The stock has been almost unstoppable since the election. It is one of the biggest players in the bond insurance market, selling guarantees against corporate defaults. It may not be the most exciting business, but it boils down to risk and interest rates. When interest rates rise, the company rakes in more cash across its investment reserves.

That changed Monday when it got hit hard after a very odd downgrade from MKM Partners. The analyst himself admits that they’re having a hard time with this stock, saying, “We continue to have great difficulties assessing an appropriate value for the company.” Last week he thought AMBC made sense at $27, and he had raised his target to that price from $20. Now he’s pegging it at $10.

If it’s a relatively small firm that admits to having trouble, why the extreme selling? First, AMBC is a lower-volume stock with a smaller market capitalization on a normal day, so the reaction is magnified, almost like a panic move. Second, after the huge move since the election — 26% through last Friday’s close — all of the true momentum traders headed for the exit at the same time. They were only in it because the stock had been moving higher.

We like the way the stock has traded, too, but we also like that the company is well-positioned with interest rates moving higher. It closed right on its 50-day moving average on Monday and, after the dust settles, I am very confident it will regain strength.AMBC

That’s why I view AMBC a good candidate for calls. We went deep in the money with a $17.50 strike price and out to February with the expiration, which dampens volatility and lowers risk but still positions us to benefit from any bounce in the stock. It’s also worth noting that there is significant open interest in the May $30 calls, a sign that a lot of traders are still bullish.

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