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For those who haven’t read my Citigroup article (NYSE:C), here is a brief synopsis. The markets have been pricing securities rather irrationally and the fear of bankruptcy has created disproportionate mis-pricing of assets that has rarely been seen throughout investment history. Efficient markets? Bah! Here is further proof that market efficiency has been thrown out the window with Lehman Brothers CDO’s.

News of General Motors (NYSE:GM) potential bankruptcy has been plastered all over headlines as of late. Rick Wagoner resigned as Chief Executive Officer as per delicate nudging of President Obama and the future of GM looks bleak for their June deadline. Few must believe there is any hope: Due to the bearish sentiment, the stock had dropped to an all time low $1.45 a share and the stock is far from safe from being reintroduced to such catastrophic levels.

However, the mass hysteria behind GM’s potentially short-lived future has created another grand trading opportunity: More specifically, a box spread strategy on GM’s May options. GM’s options have become so dramatically mispriced, that large gains are possible from a (theoretically) riskless opportunity. I say theoretical, since there are inherent risks with executing the trade properly, and not getting the correct prices on either side. And as always there are call risks in shorting any option position: there is the possibility the buyer of the option will exercise their rights to buy or sell the stock at potentially unfavorable prices. Were these options European style, this would be a truly risk free arbitrage.

In options trading, a box spread is a series of long and short call and put options, that has a (theoretically) certain outcome. This is due to the delta neutral position one takes (for those who speak Greek), and the payoff should normally result in the risk free rate of return. However, with GM’s options, there seems to be a lot more “Free” than “Risk”.

The strategy entails shorting a call option and going long a call with a higher strike price (A.K.A shorting a vertical spread on the calls). Simultaneously, one takes a short position in a put option (with a strike that is equivalent to the long call position) and goes long a put with the same strike as the short call position. Basically it is a combination of a bull put and bear call credit spread. The payoff to the investor at expiration is the credit from both the call and put spread less the difference in strike prices of the options.

For those who are absolutely lost, allow me to apply this box spread strategy to the GM May options. While I am using closing prices, the anomaly seems to persist even during trading hours (although it is uncertain for how long). GM’s stock closed at 2.09. Its 1.00 strike calls closed with a bid of 1.01 and ask price of 1.04. The 1.00 puts closed at .28 by .29. The 2.00 calls went for .39 by .41 and the 2.00 puts closed with a bid of .91 and an ask price of .94. Now, here is the trade:

· Short the May 2.00 Put options at .91

· Long the May 1.00 Put options at .29

· Short May 1.00 Call options at 1.01

· Long the May 2.00 Call options at .41

When placing this trade, the credit from the call spread is 60 cents (=1.01 - .41). On the put spread, you also receive a credit of 62 cents (=.91-.29). The total amount received is 1.22 upon execution.

On the expiration date for the May options (5/15/09) the amount due is 1.00, regardless of where GM closes. If GM was to close at 0, you lose 2.00 on the short put but gain 1.00 on the long put hence net amount owed is 1.00. If GM closes at 1.50, the short calls and short puts are each worth 50 cents which is a total of 1.00. If GM were to close at 10.00, the short call options are worth 9.00, the long call options are worth 8.00 and you owe 1.00. The amount received at initiation of this strategy is 1.22 and the amount due regardless of GM’s closing price will ultimately be 1.00. The investor will recognize a 22 cent return for a holding period of a little more than a month. For those who claim there is no free lunch, Bon Appetit.