Double up double down on BSC

I rarely offer insight into option trades that are not resident on the Mx. However, this trade is one of the rare instances, that I wanted to share with readers of the blog.

Every once in awhile, an option trade comes along that seems well… almost too good to be true. Of course there is no such thing as a perfect trade, but sometimes the numbers look so compelling, that the trade is worth a second look.

This trade comes to us thanks to Bear Stearns (symbol BSC, listed NYSE), or JPMorgan Chase (symbol JPM, listed NYSE), if you prefer. Unless you have been away on an extended holiday, you know that JPM made a shotgun offer to purchase - or bailout – BSC on Sunday March 16th.

The offer, which left BSC with bankruptcy as an alternative, was accepted in principal. Currently, it awaits approval of BSC shareholders, which is expected to occur by the end of the second quarter.

For the record, the offer was not actually US$2.00 per share. In reality, it was an exchange offer, where JPM offered to exchange 0.05473 shares for each BSC share. JPM closed at US$45.97 Thursday, which assuming the deal goes through, values the BSC deal at US$2.52.

BSC closed at US$5.96 on Thursday, more than double the value of the JPM deal. Clearly, speculators are betting that BSC will be able to wiggle some additional money out of JPM. That may be wishful thinking. The other possibility is the appearance of a white knight willing to top JPMs’ price. Also most likely, wishful thinking.

For one thing, it is not likely that the US Federal Reserve would be willing to take some of the weaker BSC debt if a white knight appeared. Nor is it likely that any white knight will be able to put aside sufficient reserves to deal with potential litigation from this deal.

Remember, JPM set aside US$6 billion to settle litigation which is sure to come. In fact, when you consider the JPM reserve fund, the deal to buy BSC is closer to US$50 per share, than Thursday’s US$2.52 per share.

The deal is expected to close by the end of the second quarter 2008. That’s an important detail, because it provides us with a window as to how long we can expect the stock to remain in a speculative state. More on that in a moment.

The fact that BSC is experiencing a speculative bubble has created some interesting option prices, which leads to an even more interesting option strategy. One I like to call the double up double down trade.

The idea is to buy some shares of BSC and write an at-the-money call and put against the position. The stock will either be called away if the stock is above the strike price of the call, ideally yielding an exceptionally high return (double up). Or if the stock is below the strike price of the put, will require you to buy twice (double down) as many shares. It works best when you have high option premiums which of course, reflect the uncertainty – or speculative frenzy – in a position.

Currently BSC options are trading with a 230% implied volatility. That meets our definition of high option premiums. Putting some numbers on this, with BSC trading at US$5.96 per share, the BSC April 5 calls closed at US$1.95. The BSC April 5.00 puts closed at US$1.20.

With this trade, we would buy say 1,000 shares of BSC and write 10 BSC April 5 straddles. Which is to say, we would sell 10 BSC April 5 calls at $1.95 and 10 BSC April 5 puts at US$1.20, for a total premium of US$3.15.

The premium received reduces the cost of the initial purchase to US$2.81 (US$5.96 initial purchase price less US$3.15 in premium = US$2.81). So, if the stock is above US$5.00 per share at the April expiration, you will simply sell your initial 1,000 shares at that price. Your return in that scenario, is 77.9% over 29 days. Note you have to set aside sufficient margin to meet the obligation of the short put, which if you include that in the discussion, reduces the actual upside percent return.

What we know for certain, is that BSC will either be above or below US$5.00 come the April expiration. If it is below US$5.00 per share, you will be required to buy another 1,000 shares at US$5.00 per share. At that point, you would own 2,000 shares of BSC with an average cost of US$3.90 per share (1,000 shares at a net cost of US$2.81 + 1,000 shares at IS$5.00 = an average net cost of US$3.90).

So what is the risk? For that, we come back to the takeout offer that would apply to your worst case scenario - i.e. owning 2,000 at US$3.90 - which again, is US$2.52 as of Thursday’s close. Give or take pennies depending on where JPM is at the April expiration.

The point is, unless JPM goes to zero, the downside on your worst case scenario is probably somewhere north of US$2.00 per share. Obviously, this creates a huge loss on a speculative trade, but the loss is not likely to be zero, which is generally the risk for these types of option trades.

At the April expiration, you still have excuse the pun… options. Assuming you end up with 2,000 shares of BSC, you could write May at-the-money calls assuming, as I said earlier, that the deal does not close until late June.

If at that point, the BSC options are still trading at 100% + implied volatility, you would likely net enough premium to net this trade out to zero. Which is to say, no gain or no loss.

Make no mistake this is a speculative trade. One that is rarely available in the options market. And one that normally has downside risk to zero. Having said that, I cite one final caveat, use only speculative money that you can afford to lose.