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Tuesday, September 16, 2008

lessons from AIG Insolvency , LEH Bankruptcy Crisis: Timing of Purchases of Penny Stocks of Major Companies

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As we predicted on this blog on the night of Sunday to Tuesday, Barclay's is going back to take (at least) partly LEH. We also announced that we planned a purchase of LEH stock (We did it on Elite trader forum, for the main reason to see the reaction of experts over there). To our surprise the majority do not understand some basic principles on whether and how to buy stock of major companies that have become penny stocks.

Here is the copy of the post of Monday:

"As I wrote in RFT's blog, last night (Sunday to Monday), I read various reports and came to the conclusion that the LEH situation, and the previous week buyers retreat were a tactical move, to sell LEH to Barclays later.

I placed an order to buy LEH (penny) stock. (A cheap call options, with high risk).

What do you think? who is onboard?"

There were various responses, ranging from mockery (sometimes insults), but there were also few thoughtful comments. Some from people whom I believe are smart money, and are intelligent and experienced.

But here are some principles that I would like to touch upon (the complete discussion and coverage of principles will be written in a special report to be given to those who request it. Email address is below).

Principle 1:

Never buy the stock before the bankruptcy news is out. You do this because you want the component in the stock price that relates to the probability of no bankruptcy to be filtered out of the stock.

Therefore you buy the stock only towards the end of the day after the bankruptcy has been announced.

In the case of LEH, you buy towards the end of Monday. Price was around $0.16

Principle 2:

Using principle one, using the close prices on the days before bankruptcy announcement and after bankruptcy announcement, you can actually derive the value of the no bankruptcy scenario. You can think of this value as the probability of no bankruptcy times the incremental value of stock under no bankruptcy condition. This a bit more evolved, but I just wanted to get you to think more. Now the interesting part is next.

The price after bankruptcy announcement is interesting. It represents the price of a perpetual call option at strike zero, with however the knoweledge that we know have which is that LEH is already in bankruptcy.

What does then the price roughly represent. Let us look at a simple model. The stock now can either be worthless or worth something with a probability (let's call it q). The LEH price ($0.16) can then be thoughtly of as: 0*(1-q) + q*(X), where X it the price of the stock under the assumption of the stock will not be worthless.

Therefore if we decide to buy LEH at $0.16, we are essentially buying q*X. Bankruptcy takes time to resolve, and buying may emergy. Therefore if there are any suprises to come, it would be that the probability Q (in Q*X) or its estimation by the market would rise in value.

The next question is, what could the value of X and Q be? This leads us to principle 3.

Principle 3:

Unless any other penny stocks, LEH and AIG stocks have option chains. This represents valuable information. The reason is that we can calculate from options prices and implied volatilities, the options estimation of the value of Q.

If we now know a rough approximate (or just some bounds on Q), we can make estimations on X.

Remember that our rewards is X-Q*X, which is (1-Q)X. This is very important to understand and internalize.

Principle 4:

Option pricing tells us that the estimation of Q also depends on the time horizon we take. (it is called time skew). It furthers tells us that the estimation of Q has a large variance compared to Q.

Principle 5:

A consequence of principle 4 is that we should sell volatility premium in going long the stock. One should therefore sell an ITM put or equivalently buy and write an OTM covered call. In addition one should average once's entry because of changes in the estimation of Q as a function of changes in price (but this aspect is less important if one were use options in implementing the long stock scenario).

The above have a sublist of principles that I would like to touch upon. As stated above, the complete discussion and coverage of principles will be written in a special report to be given to those who request it. Email address is below. Please put Penny Stock Report in the subject line).


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Happy trading,

1 Comments:

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May 25, 2010 at 6:28 AM  

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