This Insurer Could Deliver a 150% Gain to Investors
Trade summary: A bull call spread in Assured Guaranty Ltd. (NYSE: AGO) using the December $30 call option which can be bought for about $1.80 and the December $33 call could be sold for about $0.60. This trade would cost $1.20 to open, or $120 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $120. The maximum gain is $180 per contract. That is a potential gain of about 150% based on the amount risked in the trade.
Now, let’s look at the details.
As an insurer, AGO tends to have bouts of volatility. These periods can make options attractive since volatility increases options premiums. The chart below shows AGO has been volatile, falling sharply and recovering those losses in recent weeks.
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Recent news indicates the stock could be safe as ratings agencies believe AGO is sound. As reported by Business Wire,
Kroll Bond Rating Agency (KBRA) published detailed reports supporting its affirmations of the insurance financial strength ratings of Assured Guaranty Municipal Corp. (AGM) and its wholly owned subsidiaries Assured Guaranty (Europe) plc (AGE UK) and Assured Guaranty (Europe) SA (AGE SA) along with rating affirmations for Assured Guaranty Corp. (AGC) and Municipal Assurance Corp. (MAC).
In the reports, KBRA affirmed the AA+ ratings for AGM, MAC, AGE UK, AGE SA and the AA rating for AGC, all with Stable Outlooks. AGM, AGC and MAC are all U.S. financial guaranty subsidiaries of Assured Guaranty Ltd. (NYSE:AGO).
KBRA noted the following key strengths supporting its ratings affirmations:
- “Experienced management team which operates with a mature and high-functioning operating platform supported by strong governance and risk management systems” for the financial guaranty subsidiaries.
- “Ability to withstand KBRA’s conservative stress case loss assumptions across the insured portfolio” for the financial guaranty subsidiaries.
- A “corporate governance framework, credit and risk management processes” that KBRA considers “strong and reflective of industry best practices.”
- “The substantial and continuing run-off in higher risk components of the portfolio” for AGM and AGC; and for MAC, its “diverse, high quality insured portfolio.”
KBRA views the COVID-19 pandemic as primarily a “liquidity event” for Assured Guaranty, writing:
“With respect to COVID-19, KBRA continues to view this as primarily a liquidity event in the near term as financial guaranty policies only cover scheduled debt service.”
The company noted this is a positive,
“We are pleased that KBRA affirmed the AA+ stable financial strength ratings of AGM, MAC, AGE UK and AGE SA and the AA stable financial strength rating for AGC,” said Dominic Frederico, President and CEO of Assured Guaranty.
“KBRA’s view that the COVID-19 pandemic is primarily a potential liquidity event for Assured Guaranty implies that related claims, if any, will be reimbursed by the obligors.”
AGO is now facing resistance and a breakout could propel the stock towards new 52-week highs.
A Specific Trade for AGO
For AGO, the December options allow a trader to gain exposure to the stock. This trade will be open for about three weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A December $30 call option can be bought for about $1.80 and the December $33 call could be sold for about $0.60. This trade would cost $1.20 to open, or $120 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $120.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in AGO, the maximum gain is $180 ($33- $30= $3; 3- $1.20 = $1.80). This represents $180 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $120 to open this trade.
That is a potential gain of about 150% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying AGO could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.