What Buffett Selling Moody's (NYSE:MCO) Shares Could Mean For Option Traders

Moody's option strategies Although Warren Buffet is a “huge bull” toward the U.S. economy, there are names within the market that he's not as optimistic about. Buffett's company, Berkshire Hathaway, filed to sell 1.3 million shares of Moody's Investor Service MCO earlier this week. Throughout the year, Berkshire has been unloading large blocks of its long-term stake in the ratings company.

At the end of the last quarter, Berkshire's total stake in Moody's was more than 30 million shares, so what's the sale of 1.3 million shares mean, really? It's the fact that this has been somewhat of a trend that has investors nervous.

The stock is down 20% from its 52-week high of $31.04 (reached in late March) but recently punched back above its 10-day and 20-day simple moving averages (SMAs). Will Warren's latest move nip Moody's recovery attempts in the bud, or is he selling at the right time?

Investors who don't want to take on the risk of a short sell could consider option strategies such as the bear call spread we've outlined below. And for those who aren't worried about what's going on in Omaha, we've outlined a potential strategy for the bulls.

These strategies are for educational purposes only and should not be construed as recommendations. All prices are of Thursday midday. MCO shares were virtually unchanged at $24.85.

Bearish Option Strategy: Bear Call Spread

Buffett's sale of MCO shares could suggest that he expects limited upside from here. Investors who agree with this thesis could sell a short-term bear call spread. The October 25/27 call spread can be sold for a net credit of 65 cents (selling the 25 strike, buying the 27 strike).

At expiration in 30 days, if the shares are trading below 25, gains peak at this 65-cents credit. On the flip side, losses are capped at $1.35 per spread if MCO is trading north of 27 when the options expire. Breakeven for this spread is $25.65, or the short strike plus the credit. As long as MCO is trading below this level when the options expire, the spread will be profitable. The profit/loss charts below are created in a virtual trading account.

Bullish Option Strategy: Calendar Spread

From a technical analysis perspective, MCO is showing some signs of life. Traders with a long-term bullish outlook can hedge against any short-term, Buffett-related selling pressure with a call calendar spread. Shorting the October 25 call for a credit of 98 cents helps offset the cost of the January 2011 long 25-strike call, which is priced at $2.00 a contract. The net debit for the spread is consequently $1.02.

This strategy is most successful in the event that MCO stalls for a few weeks while Berkshire unloads shares but then ramps higher after the market absorbs them. When October options expire on October 15, gains are theoretically highest right at the 25 strike, as the October option expires worthless but the January option has time remaining to participate in potential upside.

If the stock is trading above $25 at October expiration, the short call will be assigned, creating a short stock position. The combination of this short stock and a long call is the synthetic equivalent of a long put and will have the same risk characteristics (losses limited to the premium, gains unlimited down to zero). Bullish traders would likely buy to close the short stock in at this point leaving the long January 25 strike call.

Between October and January options expiration, the trader has the option of holding on to the 25-strike long call. If the October option expired worthless, losses for this naked long call are limited to the overall premium paid ($1.02) if MCO is below 25 when the January options expire. Gains are theoretically unlimited at expiration if the stock rallies above breakeven of $26.02.

Trade management of a calendar spread is critical as the first expiration date approaches so the trader is left with the market exposure he desires. In most cases, the shorter-term short call would be covered and bought to close before expiration, leaving the trader long the later-dated bullish call.

Option traders! It's expiration week – time to consider the risks. Check out our webinar archive and download the webinar Jared Levy and I hosted earlier this week to discuss some trends and potential risks surrounding Expiration Friday.