A Bombardier Covered Straddle

There is little doubt that Bombardier (TSX: BBD.B, Friday’s close $1.62) is on life support. At issue is the diagnosis. Does the company follow in the footsteps of Blackberry to survive as a shadow of its former self? Or does the company collapse under a mountain of debt and litigation in much the same way as Nortel?

Unfortunately, no one knows which is why Bombardier is not a stock for long term investors. However, the BBD class B shares have options and under the right conditions there may be short term opportunities for aggressive speculators.

What we do know is the Bombardier is caught in the middle of a fierce tug of war between bulls and bears. The company manufactures excellent products with a solid market in Canada. Not so much in other parts of the world. Particularly when it comes to subway trains and executive planes.

Despite the problems Bombardier class B shares are up more than 100% since mid-February when they hit an all-time low of $0.72. Some might say this is simply a bounce from a longer term bear trend… although bounces do not normally end with tripe digit advances.

Bulls might argue that Bombardier is a turnaround story! Although not many would take a long term stake expecting to see a return to better times. More likely they are hoping the company wins enough contracts to remain viable.

That latter point is critical. A viable Canadian manufacturing company based in Quebec providing good paying private sector jobs carries a lot of political currency. Is it possible that the Federal government and Quebec Legislature might look at Bombardier as politically, if not systemically, important?

What we have then is a low priced stock with available options and no discernable long term trend. Makes an interesting case study for a short term covered straddle. I say that because holding BBD.B shares while selling both calls and puts with the same strike price and expiration date is a volatility trade; not a directional trade.

For example, you could buy say, 1,000 shares of BBD.B at $1.62 per share while selling the BBD.B May $1.50 calls (trading at 25 cents per share) and BBD.B May $1.50 puts (trading at 14 cents per share). The sale of both the calls and the puts will net you 39 cents per share in premium income. The long stock covers the short calls while cash or margin secures the obligations attendant with the short puts.

This is a short term speculation with an expiration date in just over a month. At the May expiration, either BBD.B shares will close above or below $1.50. If BBD.B shares are above $1.50, the puts will expire worthless and the calls will be exercised. At which point you deliver your BBD.B shares to the call buyer. Under this scenario the one-month return is 16.77% which occurs if BBD.B stays where it is, falls less than 12 cents per share, or rises.

If BBD.B shares close below $1.50 per share in May, the calls will expire worthless but you would be obligated to buy another 1,000 BBD.B shares at $1.50. Interestingly, the cost of the second block of shares is actually $1.50 per share less the 39 cent premium from the sale of the two options which results in a net cost for the second block of $1.11 per share. At this point the investor is holding 2,000 shares of BBD.B at an average cost of $1.365.

Either you earn a significant short term return or you end up with twice as many shares at a price significantly lower than Friday’s close. Which, by the way, is a real possibility and why this trade is best suited for aggressive traders.