Its late and I am beat, so forgive me for this arbitrage question. Its on MTGE. Suppose I want some common but I don't want to pay 25.00. I'd rather pay 24.00. So I will buy MTGE at 25.00(say 1000 shares) and strangle 10 spreads of the Jun15/35 for a 21.00 credit(current bid....could probably do better).
March EX happens and your shares are called away at 15 Short, leaving you down 10.00(25 long purchase, minus 15 short assigned). You carry the short 35 to OPEX and you are Put the shares at 35.00. Subtract your remaining 11.00 credit and you've effectively bought the shares at 24.00. If OPEX is B4 EX in June-- bonus---, collect the dividend. If MTGE trading higher than 25.00, score, dollar per dollar.
Risk, the share price in June is @ 20.00 and you are down 4.00. Alternatively, the share price is at 25.00 and you are up 1.00. You might ask why not just short the Jun25Put for 2.00 and that guarantees 23.00 Put price. But that exposes you to BE @ 23.00, below which, you suffer loss.
My trade above has BE's @ 14.00 and 36.00. Pretty crazy, no?
I would view (and analyze) this as two different trades:
(a) The long stock at 25.
(b) The short strangle (sell the 15 call and the 35 put).
If you can get a $1 credit for the strangle, that's your $1 profit on position (b) (between PPS 15 and 35, a pretty safe range). (Right now it looks like you can get only .30 though). A lot people sell strangles (and condors, for more safety) on a regular basis for steady income.
Position (a) has a very different profile -- the familiar one of a long stock (with dividend). Chances are it will dominate the outcome of (a)+(b).
So yes, everything that you say is correct -- but can we call it arbitrage? I would call (b) a high probability trade -- in the class of selling deep OTM or (as in this case) deep ITM options. (High probability, but the risk is, in theory, unlimited). And I would call (a) a separate trade (with a significant amount of risk).
BTW the ITM strangle is called "gut" by some people. Who knows why.
Hi Doc, have you thought about doing this trade on WMC? At these levels it offers higher divi and more undervalued then MTGE, no?
P.s. are you still holding UAN, you must be up nicely on that trade, congrats if so...
I still hold half of my original lot of JanShort30Puts. I plan on waiting until OPEX and either allowing them to expire worthless(hope), or might roll them to a back month. No hurry, as the more research I do on this company, the more I like the idea of increasing my exposure to additional ShortPuts.