Question on spreads

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nonlinear5

Suppose I think that a particular security is long-term undervalued and short-term overvalued. That is, it's trying to catch up with its fair value (which is above the current price), but it's doing it too fast. What would be a good strategy/instrument to take advantage of this discrepancy? More specifically, suppose that this security is likely to go up 20% in the next 12 months, and equally likely to go down by 10% in the next 3 months. I smell some combination of in-the-money and out-of-the-money puts and calls, but it's been a while since I read the arbitrage books. I thought of selling the front month futures and going long the longer term futures, but this doesn't seem right.

Can someone reference a web site or some other resource that discusses these types of positions/trades?

Thanks.
 
Quote from gkishot:

You need to buy the stock and if it goes down by 10% you buy some more.
More...

That would work, but I would be 10% down at some point. I believe there is a way to avoid the drawdown completely with a spread position.
 
Hi,

There are several things you can do depending on the IV level of the stock. The first thing that comes to mind is either a diagonal spread or a calendar spread. You may also be able to do a diagonalized call ratio backspread (that's a mouthful and probably overkill ;-). It all depends on the underlying volatility and IV.

Here's a link that describes one approach to what you're looking at (Bearish in the near term, bullish in the long term--diagonal spread): http://www.numa.com/derivs/ref/os-guide/os-014.htm

Good luck!
E
 
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