Trading a Lehman Collapse, Conservatively

In the days following the Bear Stearns (BSC) collapse, Lehman Brothers (LEH) was the favorite target of speculation for traders, especially those who missed the BSC and wanted their own chance to watch some cheap out of the money puts turn into real paper.

After it looked like LEH had pacified the concerns of critics, they’re back in the news [Barron's] as everyone on the street suspects the company is in a real double-bind:

 

If Lehman announces to investors that it is raising $3 billion to $4 billion to enhance capital, it will prove its critics right and set the stage for another showdown. Lehman has effectively asserted that it is OK, and if it raises capital Lehman will seriously enhance the credibility of critics, and dilute management’s credibility at the very time it needs to be believed in the market.

Yet if Lehman needs to raise capital, and does not raise the money, this public-relations problem may prove to be the least of its worries. 

 

So the stock should get pummeled if they have to announce another round of capital-raising; and obviously if they desperately need fresh capital but don’t raise it for fear of a negative reaction, the company might find itself in BSC territory.  Ultimately, it seems the only way out for Lehman now is if they are actually (currently) financially sound.

The Thesis

Maybe this is a rumor you want to buy into.  But even if you don’t care about the fundamental story, the technical picture is promising here as well.  LEH declined 11% on Tuesday, hitting its lowest point since March 17, and it did so on very high volume.  Relative strength and momentum studies are all negative, there are no support levels as far as the eye can see, and the stock is lower still in premarket trading.

Even so, shorting the stock doesn’t seem all that attractive an option here.  If Lehman proves that their assurances actually have some merit, the stock could snap right back to the 40-45 level.  Instead, we want to take advantage of the monstrous volatility that has been priced into the near-dated options.

The Trade

The July contracts are priced at a 150% volatility, so if you think that some resolution is coming in the next 44 days, that’s where to look.  Obviously, selling naked puts here is not the way to go, no matter how fat those premiums get.

1. You could sell the LEH July 40/42 call vertical for $0.34.  This is a two dollar wide vertical spread with defined risk and a maximum return of 20% on capital risked.  The only way this spread turns into a loser is if Lehman proves they really are in the clear.  Still, if the stock tanks and the Fed brokers a buyout on behalf of your uncle Louie’s pawn shop (or whatever other financial institution is left standing in mid July), 34 cents might not be all that satisfying.
2. So you could buy the LEH July 22.5/25/30 put butterfly for $1.05.  Also defined-risk, also with a nice risk-reward, this trade will be a loser only if, at expiration, LEH is at $29 or above.  Anything under that level is profitable, such that you’ll make $145 on a one-lot position if the stock is below $22.50, and up to $390 is the stock is near $25 at expiration.

Again, the idea here is that, were you otherwise inclined to short the stock, you can capture a lot of that potential downside in this name without exposing too much capital to a short-covering rally or an overnight gap up.  Both of these plays have stops built-in, so with some proper trade allocation you can use strategies like these to make a conservative play on an otherwise rather risky and unpleasantly volatile name like Lehman.

Standard disclosure: We may have positions in LEH, may never mention these trade ideas again, and if you follow the trade ideas suggested here, you may end up working at your uncle Louie's pawn shop this summer.

Comments

[muley101]

I prefer something simpler. I would not short LEH or any of the beaten down bank stocks at this point. Just watch XLS and LEH. When the MF, %R, and Vol turn up sharply, buy the stock with a bracket trade with a 2% profit exit, or if you prefer, just watch the trade and sell when the indicators reverse . I made 11% on LEH today doing this.