In last week's CDO Insight, UBS Warburg researcher Douglas Lucas highlighted the "CDO strangles" trade, where an investor takes a long position in a CDO sub tranche and shorts the seniors.
The investor in this situation benefits if the underlying credit deteriorates significantly, or if it deteriorates barely. The investor loses out if the CDO losses are "middling."
Call it a schizophrenic approach - or a credit view that extremes are more likely than normalcy. But it's not as indecisive as it sounds, Lucas argues. "Rather than being a trade for the indecisive, these positions represent a specific view as to the nature of today's uncertainty. CDO strangles are ideal for those who think the future holds little middle ground: that economic conditions will continue to gradually improve or significantly deteriorate."
So, essentially, the strangle trade is betting against the CDO performing in line with expectations, which are based on historical credit trends. That said, it could be argued that the CDO universe has indeed not performed in line with expectations. So maybe this is the safe bet.
According to Lucas, the strangle trade has become increasingly popular in today's post-Sept. 11, mid-credit cycle market, where uncertainty is the only certainty.
Warburg goes on to outline a theoretical trade based on a typical, multi-tranche synthetic CDO, examining different lose-win scenarios based on defaults, drivers of defaults, correlation of defaults and severity of defaults.
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