Wednesday, May 11, 2005

GM, Convertable Arbitrage, and Rumors

One of my friends asked me about GM today, so I said I'd write about it in my blog. Here's the deal. A lot of hedge funds use a strategy called "convertable arbitrage". Basically what they do is buy convertable bonds and sell the common stock short. If bad news hits the company (like bankruptcy for example), both the stock and the bonds will go down, but the bond will not go down as much as the stock, so they will make a profit if news is bad because the short stock position will make more money than they lose on the bonds. If news is good and the stock goes up, the hedge fund can always convert their bonds to stock to cover their short position. In the meantime in either case, the hedge fund collects interest on the bonds. (I'm simplifying things a little.) So it looks like a strategy where you can't lose money right? Sometimes weird things happen though. It had long been expected that GM's credit rating would be lowered to Junk status. At that point GM bonds and stock would both go down and as I wrote above, you still make money in the convertable-arb trade in that situation. Unfortunately for them shortly before that, something unexpected happened. Kerkorian made a tender offer to buy GM stock at a higher price than it was trading. People have a lot of confidence that Kerkorian will get involved and be able to turn GM around, so GM stock shot up. To make matters worse, GM hasn't cut it's dividend like everyone expected. This represents the worse case scenario for the converable-arb hedge funds. The stock is shooting up like a rocket while at the same time the bonds are going down do to the credit rating downgrade. So Monday a rumor was spreading that some big hedge fund blew up on this trade.

GS was down over 2 bucks on Monday. I think people were worried that GS might have some exposure to the GM convertable-arb trade. I was somewhat concerned. One more day like that and my short puts would be in the money...potentially causing me to lose serious money. Now, I didn't believe that GS would actually be hurt by exposure to the GM conv-arb trade, but I was worried that the fear might not blow over prior to options expiratoin. At that point it wouldn't really matter as far as I'm concerned. I'd still lose money.

Apparently the fear subsided. GS was up almost 2 bucks today (Tuesday). In retrospect, I should have sold GS 95 puts for the June Portfolio at the time. Unfounded fear is the ideal time to get long. I think I was so shell-shocked by the huge sell-off in GS that I didn't even bother to check June GS options out. Other than that Monday was uneventful.

Today was a pretty active day. First of all, I finally got my price for the June MO 60 puts. I wanted at least $0.70. This morning I sold them short for $0.75. I possibly could have gotten $0.80 if I had been more patient...but I had been waiting for days to get my price. I was tempted many times in the past few days to sell for $0.65. I'm glad I waited.

I also sold ONXX June 25 puts for $0.75. Normally I would kind of avoid selling naked puts on a biotech. I see them gaping up and down more than 50% all of the time. Cramer wrote an article about how there's some sort of cancer symposium this weekend and a bunch of biotechs including ONXX might make positive announcements at the conference. He liked ONXX because it hadn't run up, while the others had. I looked at the options, and these ones looked attractive. It's not like there is an FDA announcement coming out this weekend, so I don't see any potential for some huge gaps. The options are 19% out of the money, and the chart kind of looked like it had some support above that strike so I felt like there was enough safety to enter this position.

I feel like I have sold the minimum number of options for June expiration now. I would like to find more positions to enter, but the market is getting over-bought and will be max overbought around may expiration probably. It is becoming a time to sell not buy. I need to be careful not to chase the market up.

I tried to enter the GM convertable arb trade today. James Altucher wrote on Realmoney.com that this could be a good time to enter, because you'd be taking the other side of the hedge-funds that are supposedly being forced to liquidate. He writes in his book Trade Like a Hedge Fund, how to do this using prefered stock. In this case I wanted to buy GMS and sell GM at a 2:1 ratio. Of course I couldn't get any GM to short. Do to recent SEC regulatory changes, it is often very difficult for retail traders to short stock lately, but if there are massive liquidations of the GM conv-arb trade you'd think that there would be some shares available to short? Maybe this is a sign that the rumor wasn't true.

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