Morgan Stanley (MS) Covered Calls or Covered Puts: Shares in investment bank Morgan Stanley fell an additional 40% to around $7.50 this morning on worries that its bailout deal with Mitsubishi UFJ might not go through. Flaming the worry fire were concerns that Moody's may cut Morgan Stanley's credit rating. Two weeks ago Mitsubishi offered $9 billion for a 21% stake in the company At that time, Morgan was trading for $25/share. The deal is set to close on Tuesday. If it goes through, the stock is set to pop; and if not, it'll drop.
If you think that the deal will go through, then a covered call is a good bet. Remember that the lower the strike price of the call, the greater your downside protection. But this protection comes at a premium—selling a higher strike call will increase your returns if the stock is assigned. A covered call combination that I like is to sell the 2010 January 5 call (option symbol WWDAA) at $5 (bid $4.40, ask $5.70, open interest =113). If you can get the stock around $7.50 this will give you approximately 67% downside protection and 100% return if assigned. Your breakeven point is $2.50 below which you'll start losing money. The most you can lose is $2.50.
If you strongly believe the deal won't go through, write a covered put. A covered put is similar to a covered call except the situation is reversed and there is the possibility of unlimited losses. In a covered put, you short the stock and simultaneously sell a put. The April 12.50 put (option symbol: MSPV) has decent open interest of 478 and is currently selling for $7.40 bid by $8.30 ask. If you can pick up the option for say $7.70, your breakeven point (the point at which you'll start losing money if the stock goes higher) is $15.20 ($7.70 for the option premium plus $7.50 for the stock). Although this high premium gives you a lot of downside protection, note that if the stock takes a huge jump above the breakeven point, you will begin to incur a loss which will escalate as the stock rises.
Although the risk profiles for both the covered call and covered put are similar (but inverse to each other), the loss an investor can incur on a covered put is theoretically infinite while the loss is capped on a covered call (a stock can't go less than zero).
Exiting the trade
I'd get out of this trade as soon as possible after the deal status is announced on Tuesday. If you find yourself on the wrong side of it, I believe it's best to limit your loss as the stock will most likely keep trending in that direction. If you're on the right side of it, then I'd still take my profit as who knows what can happen in this market. In any case, writing in-the-money calls and puts is my favored course of action here since they offer the most protection.
Other Plays: I don't have time for more detailed plays, but you can employ the same strategy to index tracking stocks and ETFs with liquid options. Who knows? Something important may actually occur at this weekend's G7 meeting.
Market Note: The market may be setting up a relief rally (barring any further bad news) as the Dow Transports have formed a long bottoming tail and have hit the next major support level. (See chart below.) A covered call on the Diamonds (DIA—the Dow tracking stock) could be a nice play for the next couple of days, although holding anything over this weekend will be risky.
(Click on image for larger view.)
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