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By: Costas Bocelli — April 14, 2010

Trade of the Day: Waking Up from a Coma

Ambac Financial Corp. (Sym: ABK) is the embattled bond insurer that was devastated in the wake of the housing financial crisis, where it became a significant player insuring secured agency debt and collateralized debt obligations.

Once upon a time, Ambac’s business model primarily focused on insuring municipal bond offerings, which are relatively safe.  The premiums it collected far outweighed the default risk on municipality issues.

As pressure mounted to aggressively grow the business, it began insuring what have become the most toxic time bombs that plagued our financial system, taking down many of the financial giants.

As a result, Ambac has been struggling for its survival.  In fact, it ceased insuring new agency debt on mortgages, trying to stay alive through growing the muni business.  Many analysts think that this will not be enough.

Ambac has exploded to the forefront recently with heavy volume and a dramatic price spike.  Many investors are speculating on a cheap stock after the earnings report was announced last Friday.

The conundrum is whether the stock will eventually die like JPM analysts believe, or survive the meltdown by a stabilization of its remaining mortgage insurance exposure, possibly doing a deal to divest the mortgage insurance unit, cleaning up the balance sheet and  become viable as a muni bond insurer again.  That is the bet that is on the table.

If you think that Ambac has a chance, consider a cheap risk reversal to play it to the upside.  The benefit of this play, with the stock trading very low, is that it creates a natural stop on your risk.

A risk reversal is where you buy an out of the money call and finance it with selling an out of the money put in the same month.

With ABK trading 1.80, consider purchasing the NOV 2.50 CALL for .55 and selling the NOV 1.50 PUT for .75, setting up the risk reversal for a .20 credit.  November expiration is 220 days away.

Your total risk is 1.30 if ABK is worthless by November expiration.  The position has unlimited upside profit potential kicking in above 2.50.  If ABK is between the strikes, 1.50 and 2.50, both options will expire worthless, leaving you the .20 credit.

The question is will Ambac walk out of the hospital, or will it be sent to the morgue.

PLEASE VISIT A SIMILAR PLAY ON CITIGROUP IN MY ARTICLE ARCHIVE, A BULLISH PLAY ON CITIGROUP, DATED MARCH 31.

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