An Opportunity in Comerica Warrants

This will be a bit of an unusual post for me.  How often do I suggest option trades?  Almost never.  But because of auctioning of TARP warrants, there are a decent number of very long dated options trading on some bank stocks, and many of them are cheap.  I’m here to talk about the cheapest one this evening, Comerica.

Comerica warrants [CMA/WS] closed at $14.50 today, a price that makes the computer say, “does not compute.”

CMA neg vol

The Comerica warrants are trading so cheaply that they discount negative volatility.  At zero volatility, the warrants would trade 5% higher:

CMA zero vol

And at a fair-ish volatility level, 17% higher.

CMA 20 vol

Now there are two ways to extract value here.  Buy the warrant and sell short 2/3rds of a share of the common stock, which is empirically delta-neutral.

CMA delta neutral common

As the delta of the positions change, adjust your hedge in the common stock to reflect it.  The other way is not to short the common stock, but to short long dated options.  The most liquid long dated options are the 40s expiring in 2012.  The hedge would be to sell options on 170 shares of stock against every 100 warrants owned.

CMA delta neutral optionsOver ten months the transaction makes a profit with CMA stock between 30 and 53.  That is one wide band, and there is still room for adjusting hedges in ways that could improve matters.

Now, I am open to feedback from readers/bloggers who trade options.  What’s wrong with this idea?  Free money is rare in the markets, but this warrant really seems like a mispriced security.

Full disclosure: no positions

PS — note that you may not get favorable margining being long the warrant and short the option.