An Option Trader’s Way to Short Moody’s

Shares of Moody’s Corp (MCO) fell sharply on Thursday after hedge fund manager David Einhorn, who correctly questioned the health of Lehman Brothers four months before its collapse, disclosed he was shorting the venerable ratings agency. His logic- the parent of Moody’s Investors Service undercut the value of its primary business — assigning grades to bonds — after giving AAA ratings to insurer AIG (AIG), mortgage banker Fannie Mae (FNM), bond insurer MBIA Inc (MBI) and other companies later revealed to be badly overextended.

Now neither I have as much resources nor as close information as David may have. But I do want to play according to his bearish bias on MCO. I also want to protect my losses for what if he is wrong?

I am playing it via Put diagonal spread and I shall write put against it month after month. If he turns out to be right, I might multiply my returns. If he is wrong, I may still make money.

Here is the trade idea- Buy Jan 10 25 puts and sell Jun 26 puts for 2.80 debit and 1.00 margin, net cost $3.80. My break-evens are 23.8 and 29.8 by June 20. If Moody’s is in between those, I shall be making money (assuming no signifciant fall in Jan IVs). I can then roll June options to July’09 and keep doing so month after month (provided it remains bearish).

If however, By June 20, MCO stays around $25, the returns will be around $1.20 i.e. +30% for almost 3 weeks holding; and after rolling a new month with new returns will start. The risk to watch out is the sudden drop in the stock; two scenarios either gap-down at open or drift lower during intraday. Not much I can do in the 1st one, but for 2nd scenario I may use intraday trading/swing strategies where buy back the short puts and sell those again at the close or at the “upside reversal” of MCO.

Disclaimer- As of this writing I own the above spread but I may change my position any time. Should you decide to follow this, pls do due diligence before investing. Pls make sure you have worked out risk managemet plan in advance.

Profitable Trading, OP