Beginning Traders

BeginningTrader.com

I'll take a break from talking about the indexes and take some time to talk about credit card arbitrage. What is this you ask? Well it is when you take out a low (sub 3%) or 0% balance transfer and instead of paying off an existing loan you deposit the money into you brokerage account and invest it at a higher rate.

You'll definitely need good credit and extra cash flow to use this investment strategy. And to be preachy, you shouldn't have any high interest rate loan balances to pay off anyways! If you do, pay them off using a low rate home equity or credit card offer.

Is this risky? Yes and no. You'll need to earn a return greater than the balance transfer APR plus any one time transfer fees. You'll need to read the balance transfer offer's fine print carefully to find out the rate, transfer fee and offer length. For instance, if an offer had 2.99% for 12 months plus a 3% transfer fee (no maximum) your investment would need to return a bit more than 5.99% just to break even. I wouldn't do it for anything less than 7.49%.

Is it possible to find something that will provide a 7.49% return over one year with almost no risk of losing your investment? While nothing is absolutely risk-free, there are ways. In a normal market treasuries can be used in credit card arbitrage but currently the rates on 1 year T-bills are too low.

So what can we use now to make some money with credit card arbitrage? A high dividend paying stock plus both puts and calls. Your risks are that the stock stops paying the dividend and/or declines signifcantly in price.

Credit card arbitrage example

Let's say we feel confident that BX (BX) will continue issuing its $1.20 / year dividend. Currently that is a yield of 8.5%. If you can take out a 0% credit card loan with a 3% transfer fee you could make a 5.5% return by buying BVF. That's equal to about $550 for a $10,000 loan. Of course, you could only make that if the stock didn't decline.

How do we increase our chances of making some money using BX? We'll buy some January 2011 $12.50 puts and sell some January 2011 $15 calls along with the BX. So our trade becomes buy BX at $14.25, buy the Jan 2012 12.50 puts at $1.55 and sell Jan 2012 15.00 calls at $1.55. For each $10,000 we could buy 700 BX and 7 puts and sell 7 calls for a total debit of $9975 plus commissions. 700 BX multiplied by $1.20 in dividends equals $840, $10000 multiplied by 3% transfer fee equals $300. Therefore, this credit card arbitrage scenario would earn you approximately $540 for a low risk 5.4% return.

So what happens if things go south and BX falls. How much could you lose on this trade? Well you bought the Jan 2012 $12.50 puts so any futher loss below $12.50 is covered because the puts will increase in value. Breakeven for this trade is when BX trades at about $13.50 during Jan 2011, max loss is $1.75 / share if BX trades below $12.50. You have to eat the loss between $14.25 to $12.50. If BX traded below $12.50 the position would look like this.

  • 700 BX at $12.50 = $8750
  • Dividends (700 * $1.20) less CC fee ($300) = $540
  • Total of $9290 or a loss of $710 + commissions

With Credit Card Arbitrage you are trading a relatively certain smallish return for a relatively small loss. For the max loss to occur BX would have to decline 13% or more within the year, but this position's max loss is about 7.1%.

BX could also be called away from you since you sold the Jan 2011 $15 calls. If they were excerised against you would get $10500 for the shares + you would still own the puts. Depending on when the exercise occurred the puts might still have some value and you would then sell those. An exercise against you should produce a small profit. $10500 less $300 CC fee less commissions + value of puts + any dividends paid out before exercise.

When entering this type of trade you have to feel fairly certain the the stock you are purchasing has a low risk of falling significantly. If you felt that the stock had a good chance of increasing significantly you could gun your return by buying higher out-of-the-money calls than the ones you sold. This would decrease or even almost eliminate your return if the stock did not move as much as expected, but could greatly increase your return if the stock did rally.

Going back to our example if we added a purchase of January 2011 $22.50 calls at $0.20 each it would cost us an additional $140 + fees(we would have to borrow another $200 or so from the CC) so if it did not rally above there our gain would decrease by that amount and our loss would increase by that amount. However, if BX went to $30, our gain would be the same as above plus an additional $5110 less fees.


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