Trade Alert – (JPM) May 29, 2012

As a potentially profitable opportunity presents itself, John will send you an alert with specific trade information as to what should be bought, when to buy it, and at what price.

Trade Alert – (JPM)

Buy the August, 2012 (JPM) $25-$28 call spread at $2.65 or best

Opening Trade

5-29-2012

expiration date: August 17, 2012

Portfolio weighting: 25% = 100 contracts

This is a bet that the JP Morgan shares (JPM) will not trade under $27.55 by the August 17 expiration, or down $6.05.

That is below the 2011 summer closing low, and down 18% from today’s price. In fact, last Monday could have been the capitulation bottom for the entire move down that started in April 2. By my calculations, to get (JPM) down that far, the S&P 500 (SPX) would have to fall below 1,150 by August, which I believe is unlikely, given all the liquidity that is still awash in the market.

This is far and away the world’s premier banking institution. Estimates of the huge trading losses by the London “whale”, initially pegged at $2 billion, have since skyrocketed to $6 billion. I’ll ignore the Internet rumors that speculate about a $30 billion hickey. As you well know, almost everything on the net is not true, except what is in my own newsletter.

Back in the 1980’s when I was at Morgan Stanley, the inside joke was to look for nice office space for ourselves whenever we visited clients at (JPM). The expectation was that they would take us over when Glass-Steagle ended, as they were both the same institution prior to 1933. When the separation of commercial and investment banking finally came in 1999, Morgan Stanley had grown far too big to swallow and the egos too big to manage.

I’ll tell you another way to look at this trade. (JPM) lost 4.7% of its capital, so Mr. Market chewed 30% out of its capitalization. For you to lose money on this trade, 40% will have to go. Sounds a bit overdone, no? The bad news is already in the price.

I have known Jamie Diamond for a long time, and can tell you that he is the best manager of a financial institution anywhere. I have been warnings him for years that his traders were understating risk and leverage in esoteric derivatives in order to boost their own bonuses. It was just a matter of time before they blew up. Presumably, by now Jamie has tightened up internal controls and in the future won’t pay so much attention to presentations by wet behind the ears traders pitching schemes that are too good to be true.

I have analyzed the specific trade that got (JPM) into so much trouble, the now infamous “Investment Grade Series 9 Ten Year Index Credit Default Swap.” The chart of its recent performance and its hedge is posted below. It was in effect a $100 billion “RISK ON” trade that came to grief in early May.

The trader involved, Bruno Iksil, broke every rule in the trading Bible: too much leverage in an illiquid credit derivative with no real risk control and hedges that were imprecise at best. As I never tire of pointing out to hedge fund newbies, when your longs go down and your shorts go up, you lose money twice as fast as a conventional long only fund. Play at the deep end of the pool, but be aware of the risks.

Few outside the industry are aware that this was a $6 billion gift to two dozen hedge funds who are now posting record performance. It is, after all, a zero sum game. Didn’t Bruno get the memo to “Sell in May and go away”? He obviously doesn’t read The Diary of a Mad Hedge Fund Trader either.

Even if the worst case scenario is true and the $6 billion numbers proves good, that only takes a 4.7% bite out of the bank’s $127 billion in capital. It is in no way life threatening, nor requiring any bailouts. These shares at this price are showing an eye popping low multiple of 7X earnings, and have already been punished enough. Getting shares this cheap in this company is a once in a lifetime gift, and twice in a lifetime if you count the 2009 crash low.

If this spread expires anywhere over $28, as I hope, your total profit should amount to (100 X 100 X $0.35) = $3,500. That gives you a profit on this less than three month play of 13.2%, or 3.50% for the notional $100,000 model portfolio. Professional options traders do this sort of trade all day long. This is the same as taking $6 out of the stock on a non-leveraged basis.

When I first ran the numbers on this transaction, I had to rerun them three times because the returns came out so high. On closer examination of the intricacies of the options market, I realized that the implied volatilities for the puts have been driven to insane levels. (JPM) is one of the most widely owned stocks in the US by conservative pension funds and high net worth individuals, and those that can have been paying through the nose for short term downside protection, whatever the coast. Entering the trade with these precise strikes gives you a chance to sell short the $28 leg at the sky high implied volatility of 50.33%, a four year high for (JPM). Hence, the great opportunity is there.

If Greece forces us into major meltdown mode, we can always hedge this modest “RISK ON” trade through taking more aggressive “RISK OFF” positions, like selling short the (FXE), (SPX), (IWM), (GLD), or the (SLV) by buying puts.

Don’t place a market order for this trade or the floor traders will rip your eyes out. Don’t place individual orders for the legs either. Instead, place a limit day order in the middle market for the call spread only around $0.35, and wait for the market to come to you. It will find you.

Spreads can be wide on the deep out-of-the-money $25 calls. If nothing happens then start raising your bid in 5 cent increments until something happens.
These are the trades you should execute:

Buy the August, 2012 (JPM) $25 calls at                $9.05
Sell short the August, 2012 (JPM) $28 calls at        $6.40

Net Cost:                                                          $2.65

Expiration calculation

Value at Expiration ($28 – $25)                             $3.00
Cost:                                                                 $2.65
Profit:                                                               $0.35

Short Red and Long Black Was Not Good