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Tuesday, September 16, 2008

AIG solvency crisis: solvent or involvent, trading options on American International Company (AIG)

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Let us address the following tpic: AIG solvency crisis: solvent or involvent, trading options on American International Company (AIG).

This morning AIG started the day at around 1.25. A seasoned trader should have gone long this stock without hesitating. I will explain why and how best to go long this stock.


1. AIG (American International Company) is too big to become worthless in a matter of a few days from the price of $1.25. Before this happen, at least some groups (government, Fed, etc) will attempt something or at least pretend to. This should take some time, which means that the stock would take sometime to head to zero if it would ever head to zero. The point is that the zero floor would not be reached too soon.

2. The second observation is that related to the average trading range. It has been around 3.75. This is the difference between the low and the high of the day.

3. Since a stock cannot go below zero (and even in bankrupcy proceeding the stock will still be above zero), it means that this stock would still reach the $3.75 price level when it trades below it.

4. It takes time for the average true range to contract (valility goes up fast, and goes down slowly).

Trading plans:

A. Based on observations 2. and 3, one could just go long the stock when it is at $1.25. A no brainer.

B. One could also exploit point 1. above, and point 4, by selling time and volalility. How to do this?

Sell in the money puts, which are having juicy premimum even for expiration on this FRIDAY! (three days only).

The ITM put for $5 strike was trading around $4 when AIG was trading around 1.50. This represents $3.50 intrinsic and a juicy $0.50 volatility premium for holding just for at most three days.

Once selling the ITM put at strike $5, one can do other trades to lock gains once the stock rises.

The stock has risen to $5, the put reduced to less than $2, and one can at that point sell a call to build a position with no losses on the down downside or simply take the profits off the table. I favor the OTM call at a much higher strike (maybe a leaps with a juicier premium and high delta as volatility is really high).

We will play it again tomorrow Wednesday if it ever goes down to the $1.25 level!


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Happy trading,

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