An Unconventional Option - Go Long Financials

Once-proud financial-service companies have been humbled, and currently trade at lowly prices usually reserved for unknown, unremarkable companies.

Citi (C) ended at $2.31 at Monday's close. American International Group (AIG) closed below a dollar. Both stocks are up roughly 250% off of all-time lows, but the future of the shares (and companies) are hazy at best. Risk-averse investors don't necessarily want to gamble on such risky companies, especially while daily price fluctuations are so extreme. At the same time, however, bullish investors may want to be exposed to potential upside in shares of such trampled companies.

Rather than owning the shares of stock, investors could gain exposure to upside movement by selling naked put options.

Selling "naked" puts refers to selling puts without actually being short shares of the stock, which would sometimes create a riskier situation for the seller. However, with C shares so close to $0, even the worst-case scenario is very clear.

When puts are sold, the seller's account gets credited with the amount of the sale and an outstanding obligation shows up. If shares do move lower, the size of that obligation increases as the puts increase in value, and the seller essentially loses money. If shares increase in price, the size of the obligation gets smaller, and the seller enjoys some paper gains.

Below is a table of C January 2010 puts (courtesy of Marketwatch.com)

click to enlarge

Though there is little to no volume in the far in-the-money puts, the bid and ask spreads remain reasonable and transaction costs do not inhibit using this strategy. Options close to the current share price retain time value, providing a bonus for the seller.

At the $2.50 level, options traded hands Monday at roughly $1.25 (we'll take the bid), implying that investors expect C shares to be worth no more than $1.25 in January of 2010. If shares close below that level, the put seller will lose money. If shares became completely worthless ($0) before then, the put seller would essentially owe $250 per contract while he was only credited $125 at the time of sale. However, if shares only appreciate 10% (to over the $2.50 strike price) within the next 10 months, the seller will get to keep the entire credit at the time of sale.

Utilizing this strategy with in-the-money options changes the risk and reward involved. If a seller sold $10 puts for $8.05, he has a possibility of making $800 per contract (if shares close above $10 in Jan '10) while only potentially losing $200 (if shares go to $0).

Selling even farther OTM puts exaggerates the risk/return profile further. Selling $40 puts in the bid/ask spread at $38 seems possible, even though it's highly unlikely that C shares will see that share price within the foreseeable future. However, the trade can still be made. Again, downside risk is limited to coughing up $200 if shares hit $0 (which means repaying $4000 compared to an initial credit of $3800), while profit potential remains intact (a $10 share price close would net the seller $800 of profit, essentially). And with C, AIG, BAC, and many other companies trading relatively close to $0, this strategy can be employed for an entire portfolio of companies.

Requirements for selling naked puts differs based on broker, and the strategy isn't for everyone. Like owning shares, downside risk is limited (paying the entire difference between strike price and $0) if the shares become worthless, but gains are capped too (at the initial selling price of the contract). But this strategy may offer an interesting way to expose one's portfolio to the possibility of bullish performance without sacrificing too much capital.

Comments

[skwestorange:]

Don't forget that the more in the money you go, less is the time premium and hence the chances of a premature assignment, likely just when the stock moves down due a headline.

Apr 01 08:52 AM

[atavist.avatar:]

This is not good advice, given the risk to C. A better naked strategy is to sell cqu, the May $2 put, for $.37.

Apr 01 08:53 AM

[epeon:]

Well, my strategy has been (for the last seven months), to buy SKF on dips below 100 and sell it when it gets above 105. This is a very short strategy on banks and it has been, to this date, very profitable. I just don't see why I should change. I see nothing in the financials that makes the situation different. Unless BO actually passes another trillion dollar giveaway to the banks. But, at this point, even those in his own party are uncomfortable with that.

Apr 01 09:24 AM

[User 382450:]

Why buy puts while u can use the SKF and gain entire sector after the rally buss. Where are all the bears?

Apr 02 12:58 PM

[schlumpf:]

when AIG needs the next bailout ( 1. Q bailout ), where is the share price then, 0.35 $ or 1.40 $ ???

Apr 02 01:21 PM

[Eric in IL:]

Why chase the last 5-10% of the financials downside, there is way too much risk to be short financials. Everyone is taking action to help the banks, and as time goes on, they are gaining tons of deposits. Everyone ignores the power of deposits and the fact that real interest rates to end consumers have actually come down. Mortgage units are collecting tons of fees on refinancing. These guys are still gonna write-down billions per quarter, but they are getting enough other revenues in to offset them. Jumping in to SKF is really dangerous here. There are only so many times you can go to the well. Just think if GS or JPM or BAC pays back TARP funds. There will be a huge rally (even f it makes no sense), short squeeze will kill you.

Apr 02 03:18 PM

[aarc:]

No problem mate!

During the bull market, we developed ways and means to make money. Volatility was low, the trend was up - sell naket puts. You can make the same 5 to 10% profit in a year same as what most investors expect of their long-term positions.

Now, this is a very different environment. Far from what we were used to. Volatility is horrendous. Volatility can kill you in both ways in more ways than one. We struggle to survive and possibly make money in this terra incognita.

Look, the stock markets are close to if not already at the bottom. Volatility goes berserk. Citigroup went from $1 to $3.89 in two weeks - 300% price appreciation in 2 weeks while an investor who makes 10% during the bull run in one year will be too happy of the result, 30 years to make 300% when investment is not compounded.

Look at BS, AIG, FRE, ABK, MBI and other companies that got crushed in the early stages of this market meltdown. They were able to appreciate more than 2x during the time when their bankcrupcy potential were at their heights.

BS jumped from $2 to $13 in two or three weeks when their "bankcrupcy or take-over" was announced. AIG jumped from $1.25 to $5.70 in 1 week when Paulson took over nationalizing AIG. FRE jumped $0.25 to $2.95 when Paulson used his bazooka. ABK jumped from $1.04 to $10 in 2 months when most analysts have written it down to $0 value. Wamu and WB died with nary a whimper. Part of taking the risk. So far, rewards were more than ample against the risks.

Those were the early days.

Now, we have lots of companies in dire distress. Lots of companies are going go bankcrupt sooner rather than later.

The result so far is that a TON of them were able to run 2x and in some cases up 5x during this last "bear rally". Citigroup, BAC, GE, and a lot of no-name companies such as OMX, ODP, ESLR, JASO, EK, DAN, LEA, TEN, CBAK, TXT, are among others I was frantically buying as SnP approaches my target of 600 level. SnP ended up bouncing up with this "bear rally" at 666. So many other names I was not able to enter such as AFFX, AYR, BGCP, CENX, CVO, HLX, JNS, etc. Most of them were able to run more than 2x.

Many were also able to do so too during the Oct 2008 bear rally and the Nov 2008 to Jan 2009 bear rally. DRYS was able to ramp up from $3 to $17 from Nov2008 to Jan2009. AMR was able to "bear" rally from $5 to $12 in Oct (I was playing AMR since July) and many other names that were able to make more than 2x run up.

There are some dogs too such as EXR. I got crushed on CC, GM is both a success and a failure, F proved to be a success since Nov and still a success. PIR dumped me and resurrected me back to life, same with LVLT and AA.

Short the stocks and you may have to provide stop loss provision of 300% - stupid and nobody will do that. Provide less than 100% stop loss provision and you will be taken out in a hurry.

You will never be able to make more than 100% profit on your capital shorting stocks per trade.

Sell the puts and you make 50% profit over extended period of time? You have to put up margin requirement for the puts so money goes unavailable for other opportunities?

We never have this kind of volatility before - we may never ever have it again in our lifetime.

Trick is to use volatility in order to gain more than 2x price appreciation. Sell half or 2/3 or 3/5 of positions in order to gain at least $0.00 capitalization on the remainders. Hold the rest and never look at them again until after 3 to 5 years before selling them. Nothing to worry about; they go UP, so much the better; they go bankcrupt, SO WHAT?

Buy stocks or ETFs such as UYG, FAS, DXO, etc. using divergence buy signals on the daily. At these levels, who cares about stop losses anymore. Use stop loss or buy puts while buying during a bull run not when the massive sell-off is almost done already.

Time to invest. Buy quality stocks to hold for at least 5 years.

Use trading techniques on high risk beaten down companies in order to gain zero capital investments. Why take too much risk on these "dying" companies? The potential upside, likewise is so huge, it is almost impossible, at least for me, to ignore.

Apr 03 01:57 AM