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Morning Update

Yesterday shares of Walgreens surged 4.2% on strong option volume to a new 52-week high after an upgrade from “neutral” to “buy” at UBS. The new price target was raised to $48 a share, but some option traders didn’t quite believe that. The biggest trade of the day was the sale of 10,000 April 42/43 call spreads for a $0.58 credit. This is a bearish trade that can make a maximum of $0.58 if WAG is below 42 at April expiration, and incurs its maximum loss of $0.42 if WAG is above 43. This trade is basically a simple bet that the stock will be lower than it is now come April expiration.

This thinking contrasts that of the analysts at UBS, who said that despite the stock’s strong performance year to date and throughout 2012 it is a buy. Prior to yesterday’s pop Walgreen had been trading off of its 2013 highs, which led UBS to declare that now is an excellent buying time. The rationale behind the upgrade was that the Alliance Boots transaction has settled and will begin positively impacting Walgreen’s revenue and EPS. UBS also expects Walgreen’s increased presence of generic drugs in its stores to boost its gross margins in 2013. Additionally the upgrade cited Walgreen’s carefully constructed loyalty program and healthcare overhaul and coverage expansions as further reasons for stock appreciation the rest of the year.

The bearish case for the stock is that it is fully valued here at a 19.2 P/E and a price/book of 2.2, which is about in line with the broader market but above the industry average. Having gains 17% in the last three months this option trader is betting that the stock is due for at least a period of consolidation, if not a moderate correction. The Dow has been up 9 days in a row and eventually this will have to end. When the market dips Walgreens is likely to get dragged down with it. In the event that Walgreens continues its rally this trade will cap its losses quickly because the spread is only a dollar wide. It can be very difficult to pick a market top, so if you are tight spreads with good risk/reward ratios are the way to go.

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