Citi Stock's Wild Ride Explained in Arb Trade

Updated from Thursday, March 5

Citigroup (C Quote) shares finally broke the buck on Thursday, but the fallen giant's rollercoaster ride toward penny stock-dom may have more to do with a popular trade for hedge funds than the company's fundamentals.

Citi and the Treasury Department last month revamped a federal bailout plan, in which the bank would exchange common shares for trust and preferred securities held by both the government and private investors.

The complicated deal drastically changed the ownership structure of the firm, and offered Uncle Sam a 36% stake in Citi. Although most of the news was widely anticipated, Citi shares plunged over 40% in trading that day, and closed down 96 cents at $1.50.

A big portion of the movement is coming not from a drastic change in the market's thesis on Citigroup -- there's little doubt the firm may not have survived without government aid -- but from hedge funds and institutional investors taking long positions in preferred shares or senior debt, while shorting common equity to capture massive differentials in pricing.

"It's a high-risk trade, but when Citi converts those preferred [shares], people will have to unwind a massive short position in Citi common," says one hedge fund manager, who is playing the other side of the bet -- going long Citi in the hope that short covering will drive the stock's price up.

Citi shares faced record volatility last month, according to Bloomberg data. But to the average investor, some of the dips and peaks made little sense.