Morgan Stanley (MS): Not Likely Out of the Woods Yet, Black Swan Structure With Defined Risk

by Dan October 6, 2011 10:53 am • Commentary

MS has clearly been the punching bag of choice for U.S. bank/brokerage stocks as a sort of proxy for the troubled weaker capitalized banks in Europe.  Frankly, while i have been short banks and the XLF through put spreads and flys all summer, I really don’t get the panic in the names as they have not been intimately associated with much of the problems that could face SocGen or BNP if there was a messy default in Greece.  The problems that I see with our banks is more a crisis of confidence similar to what we saw in 2008, but different in that our banks appear to be in an infinitely better spot from a capital situation.

That being said it hasn’t caused me to not continue to look for opportunities to make money in the event of a banking crisis here caused by unforeseen events that likely have to do with a domino affect of Euro ‘stuff” and a global recession.  Earlier in the summer I suggested a 1×2 Put Spread in BAC in Jan12 which had no risk other than the small premium outlay.  This trade has been a decent winner with continued fantastic profit potential with very limited risk…..I want to look to do the same thing in MS….I want to be clear, I have no knowledge or strong belief that this company has any specific problems, but if 2008/2009 has taught us anything, the unthinkable can happen……I want to scatter my trading book with low probability but high profit potential trades if in fact we do get a meltdown in the coming months…..and the truth is we could.

The other day MS management sent email to employees reassuring them of the strength of the company, none of which I doubt, but back to the 2008 playbook this really doesn’t matter if we are going to hell in a hand-basket, and that email will be exhibit A in the height of a crisis of the beginning of the end….I am not saying this is going to happen, but in the unlikely event that it does the following structure will be a huge winner.

TRADE: MS ($14.55) Buy the JAN12 10/5 1×2 Put Spread for .50 

-Buy 1 Jan12 10 Put for 1.26

-Sell 2 Jan12 5 Puts for a total of .76 (.38 each)

Break-Even on Jan12 Expiration: 

Profits: btwn 9.50 and 5 make up to 4.50, at 5 make 4.50 (9x your money), btwn 5 and .50 your pay off trails off again.

Losses: btwn 9.50 and 10 lose up to .50, btwn .50 and Zero lose up to .50 and above 10.00 lose all .50.

* I executed this for .48 so in spreads, as always and specifically ones with more than 2, always use limits.

TRADE RATIONALE:  I love the idea of being right on a long shot, especially when there is massive profit potential. I am using some of the profits from bank shorts this summer to put this low probability bet on…I am risking what I am willing to lose.

At the moment I am not a fan of ratio spreads for most investors as we could be in a period of undefinable risk, but this trade you are not short a tail (due to the fact the stock can only go to zero and therefore can only lose .50 on the trade if it did) which I love.


We have had a few questions on how that MS trade works... it’s a bit counter-intuitive so let me explain. The most you can lose on the ratio spread is what you pay for it... this is because the stock can’t go through Zero. Think of it this way, if you were long the 10-5 put spread, and the stock went to 0, the put spread would be worth 5. With the added short 5 put in the ratio, that 10-5 2×1 ratio becomes worth 0. So your losses at 0 in a ratio spread like this are what you pay to put it on. The only time a ratio spread works like this is when the long put strike- 2x the short put strike =0. The previous time we did this on the site was in BAC on the 5 and 2.5 strikes.