If LCC doesn't move much (to be more precise, let's say it remains in a range between $20 and $25), then the linear function provided by JPM should be close enough. But if LCC falls to $14.26, then the value of the AAG preferred stock approaches zero. If you are hedging your long AAMRQ dollar for dollar with short LCC, then you probably won't gain enough on the LCC short to cover your AAMRQ losses. eg. LCC at $23. 1.582 * 23 - 22.56 = 13.83. But if LCC falls by 38% to $14.26, then AAMRQ be worth approx $2 (haven't looked up the exact amount) because the value of the AAG preferred stock is zero. Let's assume you shorted 1,000 LCC shares at $23, and cover at $14.26. Gain of $5,740. The value of the LCC shares was 1,000 * 23 = 23,000. LCC share price $23 * 1.582 - 22.96 = $13.42 23,000 / $13.42 = 1,713 AAMRQ shares If you bought 1,713 AAMRQ shares at $11, total paid = $18,843. If they fall to $2, then you lose 1,713 * 9 = $15,417. Gain $5,740 on LCC Lose $15,417 on AAMRQ. So the correct way to hedge long AAMRQ is with a combination of short LCC and short LCC call options, to more accurately reflect the behavior of the AAG preferred stock.
Right now I'm long 1.2 AAMRQ for every 1 short LCC. I think I will buy some OTM LCC puts just in case
Shorting LCC calls is a better way to replicate the AAG preferred stock. Is there a reason you would prefer to buy LCC puts?
Margin requirements, I don't need a perfect hedge. As a long there I'm hedged against a big loss its ok. I will close out the trade when it gets popular(it might become soon if some folks post on seeking alpha)
Shorted more LCC today and bought some Dec 20 2013 $17 puts just in case there is something crazy like a terrorist attack or something
Just playing devil's advocate here - suppose LCC is at (roughly) $20 in early December, and then LCC (and its successor AAG) decline suddenly to $17 at expiry. Your puts will expire worthless. The percent decline in AAMRQ stock is likely to be larger than the percent decline in LCC stock. Will your arb still be profitable with a share price of $17?
If that happens I will consider myself unlucky and take whatever small loss I have. Just one month before they close the deal, I don't need to be that concerned. Most likely scenario is that the spread tightens out and the price is somewhere around where it is now
It sure feels like this market will go 1999 before the crash. Anyone has a good risk/reward trade to play a blow off top? Cutten? I know this is a play you like do to. Maybe way OTM Russell calls
Russell is lagging the market in the last month, maybe its better nasdaq or spy. I do think there is some kind of reflexivity going on at SPY because the hedge funds are "forced" to buy in order to not get fired by underperforming it, lots of folks have underperformed it over several years and they will go out of business if they keep doing it. This creates an incentive for them to chase rallies
http://seekingalpha.com/currents/post/1415772?source=email_rt_mc_readmore AAG stock (ticker AAL) could start to trade in december. Offers opportunity for a perfect hedge by shorting AAL and not have to hold risk for 120 days