New Trade MS- Black Swan Edition: 10 to 1 Risk/Reward Ratio Spread

by Enis May 30, 2012 1:59 pm • Commentary

I will be talking about MS on Talking Numbers between 3:20 and 3:30 pm on the Closing Bell with Maria Bartiromo.  Putting all the other fundamentals in MS aside (Facebook fiasco, JPM whale causing increased regulatory scrutiny on investment banks, offset by “cheap” thesis since stock trades at 0.4x Book, etc.), I want to point out one very important chart.

This is a 5 year chart of MS vs. SX7E (the European banks index):

If anyone had any doubt about the interconnectedness of the global financial system, this chart should put those doubts to rest.  MS and European banks have an almost perfect correlation over a very turbulent 5 years.
There are a couple takeaways here:
1)  MS generally led SX7E down during 2007 and 2008, as the financial crisis was centered in the U.S.  Over the last 2 years, SX7E has led MS down, as the financial crisis epicenter has shifted to Europe.
2)  SX7E has recently broken its 5 year lows, which bodes ill for MS.  Despite all the headline press about MS botching the Facebook deal, and analysts focusing on the regulatory environment in the U.S., investors in MS should be focused primarily on one thing:  price action in European banks.
As MS tests the $12-$13 support area that it tested twice last fall, I was looking for a cheap way to play for a break of this support if MS follows its European brethren lower.  This is a Dan Nathan classic, and a great risk/reward trade:
TRADE: MS ($13.25) Bought October 10 / 5 1×2 Put Spread for 0.50
  • Bought 1 October 10 put for 0.82
  • Sold 2 October 5 puts for a total of .32  (.16 each)

Break-even on October Expiration:

Profits with stock btwn 9.50 and 0.50, with max gain of 4.50 if stock is at 5.00 on expiry.

Losses of up to 0.50 btwn 9.50 and 10.00 and btwn 0.50 and 0. Losses of 0.50 above 10.00 on expiry.


Since MS is already so oversold (down almost 40% in 2 months), I don’t feel too comfortable playing for a break in MS with a short duration option bet as we could easily get an oversold bounce soon.  The October 1×2 ratio put spread gives me almost 5 months and a great risk/reward payout if the financial crisis in Europe is not resolved over the summer, and even if we get a near-term oversold bounce, my ratio spread should not lose much of its value over the next couple months.

We love these sorts of trades that have massive profit potential with defined risk in the event of a Black Swan sort of event!  This trade is for those who have a bit of a risk budget, meaning, they are playing with the houses money and have money to lose, because I will need a massive move to break-even on Oct expiration.  MS is a name that we have been spot on with over the past 6 weeks, and while we hate pressing shorts like this, the risk/reward of the structure is causing us to spend a little premium to play for the Big One.  This is trade isn’t for everyone, but after nailing the recent highs, we just can’t resist.