Writing Calls against Citibank Convertible Preferred Stock

| About: Citigroup Inc. (C)

One of the most classic arbitrages involves buying a convertible preferred stock or bond and shorting the common. If you know and understand the terms of the convertible vis-a-vis the common, you could easily try to do a little old-fashioned arbitraging.

But in this day and age of computer trading, it would be difficult for the individual investor/trader to make more than a few pennies, if you're lucky, on such a trade as computers keep such arbitrages in line. Trading firms with deep pockets could do this trade many times over and could afford to carry such a trade if it needed to be carried for any length of time.

However, for the small independent trader like myself, I would consider writing calls against a convert, especially in a stock that has been beaten down like Citigroup (NYSE:C).

The particular convertible security I am referring to is the C Pfd. H, a mandatory convertible security.

The substantive terms of this particular convertible security can be summarized as follows:

* An owner of C Pfd. H receives $7.50 in dividends ($1.875 payable 3/15, 6/15, 9/15 and 12/15) and;

* C Pfd.H must mandatorily convert to C stock based upon the closing price of C stock on 12/15/2012. The conversion rate can be seen in table below.

Price of C on 12/15/2012 Conversion Multiplier
If C <= $31.50 3.1746
If C >= $39.40 2.53968
If C > $31.50 and C < $39.50 100/Price (eg. 100/$34.50 =2.898)
Click to enlarge

Knowing the terms of this convertible, lets fast forward to 12/15/2012 and analyze some scenarios based on closing prices:

Recently, C closed @ $31.25, and C Pfd. H closed @ $92.96

C - 12/15/2012 Conversion Price Dividends Total Return
$31.25 (unchanged) $99.20 (31.25 x 3.1746) $7.50 $106.70 or 14.7%
$40 $101.58 (40 x 2.53968) $7,50 $109.08 or 17.3%
$20 $63.49 (20 x 3.1746) $7.50 $70.99 or -23.6%
Click to enlarge

Now consider selling the C September 40 Calls that are now trading $1.53 - $1.58. You can sell 2.54 as many C September 40 Calls as shares of C Pfd. H that you own and you would be totally hedged even if the stock rallies above the $39.40 ceiling as per the conversion table.

Now lets add $3.93 (Sep. 40 Calls $1.55 x 2.54) to the same scenario:

C - 12/15/2012 Conversion Price Dividends Options Total Return
$31.25 $99.20 $7.50 $3.93 $110.63 or 19%
$40 $101.58 $7.50 $3.93 $113.01 or 21.5
$20 $63.49 $7.50 $3.93 $74.92 or -19.4%
Click to enlarge

Additionally, if your September 40 Calls expire worthless you could then sell December 40 Calls to enhance your returns.

If you like C, (and what's not to like, it has a low p/e and close to a $50 tangible book value per share), this is the trade to consider in lieu of buying C. Based upon the above analysis you would make some serious returns if C holds its own this year. As a matter of fact, your break-even point on this trade including the writing of the calls would be C @ $25.68 ($25.68 x 3.1746) = 81.52 + 7.50 + 3.93 = $92.56.

Disclosure: I am long C Preferred H