Citigroup Preferred & Citigroup Common (C-PP / C): Recapitalization Covered Call
U P D A T E
On July 31, tender offer participants received Citigroup common shares in exchange for their preferred shares.
T H E S I S
The public has been well informed by various media channels about Citigroup’s upcoming recapitalization. Naturally it seems that everyone and his brother-in-law is participating, as the spread in practice—0.5 percent via put options—is much narrower than it is theoretically—15.5 percent. I believe that the best procedure is to sell a corresponding number of naked January 2011 call options, $5 strike against the preferred shares purchased. This would be tantamount to purchasing the common at $1.90, with the attenuating disadvantage of limiting profits beyond $5.40.
Michael Price commented on Citigroup in a recent Bloomberg interview: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atDqUlby7VOk
Why not do the following:
Buy 1000 of the Preferred P (closed today at $19.45). Cost: $19,450 before commissions.
Sell 7300 August 2009 $1 strike calls for $2 each. Premium received: $14,600
Buy 7300 August 2009 $1 strike puts for $0.03 each. Cost: $219
Net expense so far: $5069
You receive about 7300 shares of C in the exchange. If C is below $1, you can put the stock for $1 and you gross $7300. If C is above $1 you are called away at $1 and gross $7300.
Your $7300 gross minus your $5069 cost is $2231 in risk free profit.*
Technically the risk is that some problem with the exchange offer delays things past the expiry of the August options.
And to answer my own question, the risk is one of assignment. Regardless of the expiry date on the calls sold, there is a chance that some or all of them will be exercised immediately. If they exercise before your preferred has converted into common, then you have to buy common and sell it in order to satisfy your obligation. And then you have to re-sell the calls to let you do the arbitrage.
Whereas with Cogitator’s strategy, the call can only be an issue if the stock rises above $5. But if the stock falls far below $3, then that strategy can result in a loss.