Don't Let the Banks Break You: Hedge Yourself with These 15 Option Strategies

It's Wednesday June 24, 2009 and on my long ride home last night I switched between Sirius (SIRI) channel's 129 and130 or CNBC radio and Bloomberg radio. As I expected, I heard more of the same talks about an overheated market and that we're due for a pull back. One analyst predicted a market correction to 850 on the S&P and the other predicted an even greater pull back to 800 by summer's end. However one analyst gave a 50% chance the market would get to 820 and a 50% chance we could continue the rally through summer. Although I cannot comment on this as a professional, I also believe we could see a pull back, but I'm leaning more toward the 850 range on the S&P.

I am devoting this post to the financial sector in particular as we've experienced a greater rally in financials compared to other sectors. Although the financial sector has been beat down the hardest over the past year (as the first chart shows below), if we get this pull back expected, I believe that the financial sector will suffer the most. I used 5 ETFs to demonstrate how much more the financial sector has gained compared to the rest of the market over the past 3 months (as the second chart shows below). The ETFs used in this chart are the: Financial Select Sector SPDR (XLF), Consumer Staples Select Sector SPDR (XLP), Energy Select Sector SPDR (XLE), Technology Select Sector SPDR (XLK), and Industrial Select Sector SPDR (XLI).

(click images to enlarge)

One way to hedge the downside if you own any of these financial companies is to sell the rights to the stock also known as writing covered calls. These are option strategies which I have researched and will give at least 5% downside protection as well as a 5% return by July 18 or August 22 (if the stock happens to rally and meets or exceeds the indicated strike price at July or August expiration). To learn more about options click here.

Below is a table of 15 financial companies, symbol, month of option expiration, strike price, downside protection, % return (if strike price is met at expiration), and the current probability that the options market is factoring in for the given strike price (probability you will sell your shares at expiration).

All data as of pre-market June 24, 2009.

Company	Symbol	Month	Strike Price	Downside Protection %	% Return	Current Probability %
American Express	AXP	August	25	6	12.9	41.8
Bank of America	BAC	July	12	8.4	6.5	57.7
Bank of NY Mellon	BK	August	30	5.3	11.2	40.1
Barclays	BCS	July	17.5	6.3	8.9	46.7
BB&T	BBT	August	22	7.3	8.9	50.3
Capital One	COF	July	22	5.3	9.3	44.7
Citigroup	C	August	3	7.3	7	55.5
Fifth Third Bancorp	FITB	July	6	14.9	5.5	73.2
Goldman Sachs	GS	August	140	7.2	6.4	54.1
HSBC	HBC	August	43	5.9	7.9	47.1
JP Morgan	JPM	August	35	6.2	10.5	45.7
Keycorp	KEY	July	5	10.4	5.3	65.3
Morgan Stanley	MS	July	28	5.1	6.1	49.6
PNC Financial	PNC	August	40	8.7	10.7	51.1
Wells Fargo	WFC	July	23	6.2	6.6	50.7

The most attractive buy / write strategies or stocks to write covered calls on in my opinion are: Bank of America (BAC), Keycorp (KEY), and Fifth Third (FITB), as they are all above average (based on these 15 stocks) on % protection, % return, and probability of expiring in the money. To compare these 15 to each other I had to compute the average daily protection for each strategy and the average daily % return (if called out). As you may already know, writing stocks out for the July expiration is more attractive and will yield higher protection as well as return (25 less days in the contract until expiration).

To get a printable version of this table of stocks ranked from least to greatest in all 3 categories (% protection, % return, and % probability of expiring in the money), click here.

If you're more bullish / bearish, you’ll want to adjust the strike price and expiration accordingly. If you’re more bearish write deeper in the money calls, you will not return as much if you get called out, but if you do, and the overall market is down you’ll most likely outperform the market.

Disclosure: Long AXP, BAC, GS

Comments

[apppro:]

Don't let these guys fool you either. Options may work, but not for 98% of us. Actually we're all suffering this added volitility just so a few option traders can make a couple of extra $.
Stop the insanity! Even as Warren Buffett said the other day:
"Make it simple!"

Jun 24 06:54 AM

[BSC:]

Interesting approach.

Question:

How did you define / calculate the "current probability" ?

Thanks in advance

Bernie

Jun 24 09:16 AM

[LanceLink:]

Bernie --

Here are the problems with this, and other articles that Marco writes:

First, he bases his "return" on the possibility that the stock will be assigned. This is just based upon the hope that the stock will rise to the higher strike price. Basing your returns "if assigned" is a shaky strategy.

Second, he keeps listing a column of numbers that he says is the "current probability" that the stock will reach that strike price. He does not explain the basis for that calculation in this article, nor has he ever explained it (I've checked his blog, it's not there either). Yes, Marco, I understand that there may be some extrapolation you can make from the option price and the volatility, etc. about the chances that a stock may reach a certain price, but it's all just hope.

Writing calls is a solid strategy for income, but articles like this are not particularly useful.

Write ATM for maximum return and protection.

Jun 24 10:31 AM

[jackooo:]

Clear, concise article even for an amateur like me.
I totally use call options and recommend them to my friends.

Jun 24 11:09 AM

[kjangelo:]

selling covered calls is a good income strategy when the stocks stay the same or go down slightly , however it weeds out all your winning stocks and potentially leaves you with the losers. Also it leaves you with very little downside protection.

Jun 24 12:51 PM

[Theta Guy:]

Marco, the title should be "Just ONE Strategy.....for 15 different stocks"

Jun 24 04:33 PM

[dpf:]

Marco - just blow off the flamers - I have learned a lot from your articles and have made $ from your ideas.

Jun 24 05:41 PM

[Marco Hickey:]

Check my blog again, you must not have looked to hard.


On Jun 24 10:31 AM LanceLink wrote:

> Bernie --
>
> Here are the problems with this, and other articles that Marco writes:
>
>
> First, he bases his "return" on the possibility that the stock will
> be assigned. This is just based upon the hope that the stock will
> rise to the higher strike price. Basing your returns "if assigned"
> is a shaky strategy.
>
> Second, he keeps listing a column of numbers that he says is the
> "current probability" that the stock will reach that strike price.
> He does not explain the basis for that calculation in this article,
> nor has he ever explained it (I've checked his blog, it's not there
> either). Yes, Marco, I understand that there may be some extrapolation
> you can make from the option price and the volatility, etc. about
> the chances that a stock may reach a certain price, but it's all
> just hope.
>
> Writing calls is a solid strategy for income, but articles like this
> are not particularly useful.
>
> Write ATM for maximum return and protection.

Jun 24 06:01 PM

[19709:]

Selling covered calls is a viable way to gain downside protection on stocks you already own while enhancing your dividend yield.


On Jun 24 06:54 AM apppro wrote:

> Don't let these guys fool you either. Options may work, but not for
> 98% of us. Actually we're all suffering this added volitility just
> so a few option traders can make a couple of extra $.
> Stop the insanity! Even as Warren Buffett said the other day:
> "Make it simple!"

Jun 30 12:55 PM

[19709:]

Actually, Marco suggests I-T-M options on a regular basis where the probability of being called is certainly higher and his projected profitability numbers are consequently more likely.


On Jun 24 10:31 AM LanceLink wrote:

> Bernie --
>
> Here are the problems with this, and other articles that Marco writes:
>
>
> First, he bases his "return" on the possibility that the stock will
> be assigned. This is just based upon the hope that the stock will
> rise to the higher strike price. Basing your returns "if assigned"
> is a shaky strategy.
>
> Second, he keeps listing a column of numbers that he says is the
> "current probability" that the stock will reach that strike price.
> He does not explain the basis for that calculation in this article,
> nor has he ever explained it (I've checked his blog, it's not there
> either). Yes, Marco, I understand that there may be some extrapolation
> you can make from the option price and the volatility, etc. about
> the chances that a stock may reach a certain price, but it's all
> just hope.
>
> Writing calls is a solid strategy for income, but articles like this
> are not particularly useful.
>
> Write ATM for maximum return and protection.

Jun 30 12:57 PM

[19709:]

Whether you have very little downside protection depends, or course, on whether you're writing I-T-M or out-of-the-money calls. If you're called out of stocks you like, you can always buy them back and write additional calls.


On Jun 24 12:51 PM kjangelo wrote:

> selling covered calls is a good income strategy when the stocks stay
> the same or go down slightly , however it weeds out all your winning
> stocks and potentially leaves you with the losers. Also it leaves
> you with very little downside protection.

Jun 30 12:59 PM