The worst keep secret in the hedge fund world for the past month has been the so-called Citigroup pair trade (so poorly kept that the well known Value Investors Club has been pimping this pick). This was a simple trade that involved buying long preferred shares of Citigroup, Inc. (NYS: C) and selling short the common shares of Citi. Such trades attempt to aribitrage the price differential between two types of shares that sit in dramatically different positions in the capital structure. Preferred shares of financials, recently, have been relatively underpriced compared to common stock in the companies. This has been true for Citigroup, among others. Here's a great explanation from Zero Hedge.

In a nutshell, dozens of hedge funds set up the pair trade in early and mid-February. Then they were blindsided when the bank giant announced a preferred for common exchange offering on Feb. 27. That offering effectively wiped out the short side of the pair trade by making it very likely the U.S. government should enter into the exchange, causing a decline in price of preferred stock.

But many funds were likely naked shorting the trade and so a massive scramble ensued to get shares to cover short positions. This played a key role in driving up shares of Citi (Our Piqqem Sentiment on Citi remains neutral, holding at just under 200 points on the 0-400 point rating scale). Tyler at Zero Hedge estimates that the minimum downside exposure held by those engaged in the pair trade was $5 billion and could go much higher depending on the final terms of the exchange, costs levied by brokers for locating and holding shares required of short trades, and price movements in both the preferreds and the commons. Worst case? This could be another Volkswagen-like nuclear bomb for many well-know hedge funds.

Alex Salkever is Director of Research for Piqqem.com, a stock prediction community powered by the Wisdom of Crowds.