Options Strategy: Risk Reversal on MBIA

Jul.13.11 | About: MBIA Inc. (MBI)

Shares of bond insurer MBIA (NYSE:MBI) surged Tuesday on speculation of an upcoming settlement with Bank of America (NYSE:BAC), closing at $9.04, up 6.86% on the day. The situation is covered very clearly in an article on Bloomberg Businessweek, and rather than rehash that information, this article presents a speculative options strategy intended to capitalize on a potential gap upward on news of an agreement. The strategy can best be described as a ratio risk reversal.

How Big Is the Potential Move?

The probable size of the gap can be appreciated by looking at MBI's chart action in the wake of two prior news items involving the settlement of differences between monolines and banks. The first of these occurred in late December 2010, when JP Morgan (NYSE:JPM) and Barclays (NYSE:BCS) withdrew from litigation opposing MBIA's transformation. The shares made a move from the $10 area to as high as $14.96, within a very short period of time.

The second occurred in mid April this year, on news of Assured Guaranty's (NYSE:AGO) $1.6 billion settlement with BofA. MBI rallied approximately $2 on the news. Here's the chart (click to enlarge image):

Click to enlarge

A settlement might be as large as $2 or $3 billion, and would render questions about MBIA's capital adequacy and transformation moot. I would guess that the potential move might be as large as $5, within a very short time frame.

The Trade

Sell to open 10 MBI Jul 16 2011 9.0 puts @ $0.29

Buy to open 40 MBI Jul 16 2011 11.0 calls @ $0.06

Prices shown are mid bid/ask as of Tuesday's close, rounded against the investor. The position has a low out of pocket cost, and can be entered for a net credit of $50.00, disregarding commissions. The investor will need sufficient cash or marginable securities to support the put obligation.

If shares expire between the two strikes, all options expire worthless, and the investor retains the $50.00 credit, less commissions. If shares are below $9.00 at expiration, he will be the proud owner of 1,000 shares. If the shares are above $11.00 at expiration, profits will accrue accordingly.

Most investors preferred the 10 strike, with 11,720 calls traded against an open interest of 5,555. I went with the 11 strike because I have a large LEAPS position, in the money, and my interest in doing another trade was to have low cost insurance against sorrow and regret if the stock made an unexpectedly large move and I didn't participate fully.

On Friday, if nothing happens, I'll give some thought to doing a similar trade on the August expiration, probably on a 4 to 1 ratio, with strikes selected based on the desire to achieve a low out of pocket cost.

Play It Again, Sam

Traders and investors have a tendency to go back to what worked in the past, whether it be a strategy or a symbol, and try to relive old triumphs. I had very good luck with this play when MBI made the big move up to $14.96, and I've been keeping an eye on it, looking for a chance to take another shot.

Jim Cramer has recommended that investors permit themselves some speculative positions, and I like something like this, where the out of pocket cost is low and there is some sort of rationale to suggest the possibility of a large move. I don't mind being assigned on the puts: Back in May CFO Chuck Chaplin bought 25,000 shares at $9.01, and I'll be happy to buy at the same price he paid.

My experience with the play it again idea has been that the first time around is the best. As the old farmer said about spreading manure in the field: "Successive applications yield diminishing gratification." Still, it's worth trying it again.

Disclosure: I'm long MBI along the lines discussed in the article, long AGO LEAPS, and have no position in the banks mentioned.