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Monday, October 25, 2010

Trade Entry -MEE Risk Reversal Option Play

Last week, Wall Street Journal reported that Massey Energy (MEE) is exploring strategic alternatives including the sale of the company. This morning, Stiffel Nicalaus published a research piece stating that Cliffs Natural Resources (CLF) may bid for MEE and the bid could be as high as $62. So far the stock has hit a 52-week low of $25.85 and 52-week high of $54.80. Massey shares nosedived following the April 5 explosion at its Upper Big Branch mine in West Virginia, which killed 29 miners. It closed at $54.69 that day and hit a low of $26.31 on July 2. The WSJ article mentioned that MEE could be in due diligence phase of a strategic move as early as November.

Today, I initiated a costless risk reversal spread to take advantage of the expected sale of MEE:

Trade Details Cost Basis
Sell 2 contracts of MEE 2010 DEC 32.00 PUT @ $0.40 ($80.00)
Buy 1 contract of MEE 2010 DEC 50.00 CALL @ $0.75 $75.00

Total Cost ($5.00) (credit)
Breakeven Price: $31.97

As long as I am willing to buy the stock at $30 (in case there is no deal), this spread provides me $5 credit initially and unlimited upside should MEE's price exceeds $50 by December 18, 2010. Statistically, there is about 7.6% probability of MEE's price being $32 or lower by the expiration date. So, I am willing to take the risk of buying the stock at this price. Also, this price level corresponds to the congestion area from which the price broke up indicating good support at this level. One thing to remember is that one would have to post margin for the Put side of the spread or cash-back the short puts ($6,400 less $5 credit).

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