The Next Shoe to Drop in Banking: An Options Strategy 13 comments
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The financial sector of the U.S. economy has had nearly a year to address the problems that exacerbated the crisis last fall. But many observers think that the banks haven’t done enough, and that another round of trouble may be developing for the sector. I will outline some of those concerns and then suggest some ways to use options to profit if there is indeed another shoe to drop in banking.
The Thesis
The primary obstacle facing large banks is that they still carry most of the “toxic assets” that caused them so much trouble last year. As Elizabeth Warren explained recently, changes to accounting rules allowed banks to appear solvent only by allowing them to continue to obscure the market value of their troubled assets. By allowing banks to continue operating without any transparency or accountability, the federal government bought the banking industry some time, but did not address the fundamental problem. While some banks have begun quietly unloading some of their non-performing mortgages at steep discounts, they cannot do so in any real size without risking large write-downs that would spook equity holders.
A robust economic recovery – especially one in which new high-paying jobs are created and consumers regain their confidence – would lift the real estate market and boost the values of troubled assets. But while the administration and the banks have further leveraged themselves on the hope that such a recovery is forthcoming, there is little reason to expect a sustained rebound. Even if we do see improvements beyond the round of cost-cutting that enabled still-paltry, if positive second quarter earnings reports, such a recovery is likely to be a “jobless” one that will be insufficient to improve the fortunes of the major banks.
Two other catalysts to watch for include the commercial real estate (CRE) market and increased predatory activity on the part of banks themselves. The CRE story has been covered in great detail and has attracted widespread attention, mostly, I think, because it would amount to a new problem scenario in addition to all the familiar problems. The federal TALF program was extended by three to six months on August 17th and is intended to facilitate purchases of commercial mortgage-backed securities, but it is unclear whether government support will be sufficient to inspire continuing weak demand.
More alarming are the new products launched by major banks like Morgan Stanley (MS), JPMorgan Chase (JPM), Citigroup (C), and Wells Fargo (WFC). According to a recent story in BusinessWeek, these institutions are now getting into the sleazy payday loan business, are offering commercial loans linked to credit-default swaps (essentially increasing the financing burden on businesses precisely when they are least able to afford it), and are now approaching retail customers with structured notes – derivative instruments with complicated terms and opaque risks. Some or all of these might boost revenues at the banks over the short-term, while also entangling consumers and banks alike in a new round of ill-advised risk-taking.
In short, the fundamental picture for the major U.S. banks doesn’t look very different now than it did several months ago, especially once we discount the temporary effects of accounting changes and short-term stimulus packages. Bank stocks seem priced for a major economic recovery, but a quarter or two of continued weakness or negative surprises from the two other catalysts we mentioned could spark a substantial selloff in bank stocks.
The Trade
Options are a valuable tool for expressing views that can’t be stated in any other way. For simple buy/sell theses, buying or shorting a stock or ETF is sufficient. But in this case, we want to take a more nuanced position. It’s entirely possible, even if unlikely, that the U.S. economy will rebound strongly and bank stocks will rise amidst a new bull market. It’s also possible that no major surprises will emerge and the banks will be range-bound for months to come. So a straightforward put purchase isn’t the most desirable way to make this play.
We want a position that is long vega – meaning that it will profit from an increase in implied volatility – since a decline in the financial sector is more likely than not to be a relatively sudden affair. We also want a position with some positive theta: since it may take some time for this pessimistic thesis to play out, we want to profit from time decay rather than let the value of our position trickle away. Finally, we want a position with some negative delta: we are bearish on the sector, after all.
click to enlarge
The XLF January 2010 10 puts could recently be bought for about $0.32; with -0.13 delta and 0.2 vega, these puts satisfy the first and third requirements. The XLF September 12 puts could recently be sold for about $0.20, and the September 15 calls could recently be sold for about $0.18. By selling this front-month strangle, we can bring in some income to help defray the cost of those back-month puts. The resulting three-legged position can be opened for a net credit of about $0.07; it will be profitable at September expiration if XLF is anywhere between roughly $11 and $15, with a maximum profit point near $12. At current levels of implied volatility, there is about a 70% chance that this position will be profitable at September expiration.
No trade is complete without a serious consideration of the risks involved. Because the front-month strangle we’re selling is only partially hedged (the long January put covers our short September put), it faces unlimited risk on the call side. As a result, it is advisable to hedge any upside breakout above $15 with either stock or long calls. We follow a version of this approach in our newsletter, and Condor Options' members have witnessed how helpful even a weekly rebalancing hedge can be.
Managing the trade after September expiry is relatively straightforward: as long as the underlying thesis of the trade is intact, we can sell short-term options against our core long position to generate income and reduce our cost basis. If the financial sector does begin to weaken, it will make sense to look further out of the money in order to allow more room for price declines.
Disclosure: No positions
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0.38 - 0.32 = 0.06
On the close of Aug 24th, 2009, XLF SEP $12 puts I see quoted at 0.05 - yeah for unlimited risk for a nickel. Skip selling put and get better buying power req.
I find it temping to sell credit spreads on XLF, but I would expect JPM,STT,BAC,STI,BBT,GS... to provide the most of the down move in XLF. In my opinion it would be better to construct credit spreads on the above stocks and do calendars on XLF for +theta +vega.
Buy XLF Oct/Sep $14 Calendar for a quarter. Breakeven 14.82, 13.26
Let's say if I'm somewhat neutral on C, I could sell straddles on it. $5 OCT straddle at the close is quoted at 1.20 with BE 3.8/6.3.
www.etfinvestmentoutlo... can be useful.
My only complaint is I didn't know exactly what they were saying. It was like overhearing a real kick-a$$ stock tip and not quite catching the name.
On Aug 25 12:39 AM User 476509 wrote:
> I think all the above creates nothing of substance. These are people
> that assist each other's ego with toxic jargon that plays to a choir
> unified in a culture of meaningless finance driven by greed and self-import.
> They have in the last year unvieled to us a (their) culture of meaningless
> (poisonous) financial products and their unapologetic search for
> the next creative and dangerous wave of financial infection. For
> God's sake, stop it. Invest in support of simple "growth" as it
> should be ... and finance to facilitate growth. Stop the pure gambling
> environment that places bets on companies losing and plays losing
> and growth against each other in the sickness of hedging. Where
> did real, basic and honorable business go? It seems that our masters
> of business feel like they have to find ever new ways to distort
> finance in search of a trade commission or a sense of invention infected
> with layers of complication. They create default swaps and things
> that "derive value" rather than create value. It is sad that our
> financial talent has come to this meaningless sense of occupation.
> Who is teaching this? Their work now hurts the world instead of
> helping it improve, grow and produce real GDP. The MBA has become
> a Master of Bogus Activities seeking the next bonus for smoke and
> mirrors and products that mean nothing real, yet bring poison to
> honest enterprise and are truly an infection behind the weakend muscle
> of honorable work and productivity.
On Aug 25 12:39 AM User 476509 wrote:
> I think all the above creates nothing of substance. These are people
> that assist each other's ego with toxic jargon that plays to a choir
> unified in a culture of meaningless finance driven by greed and self-import.
> They have in the last year unvieled to us a (their) culture of meaningless
> (poisonous) financial products and their unapologetic search for
> the next creative and dangerous wave of financial infection. For
> God's sake, stop it. Invest in support of simple "growth" as it
> should be ... and finance to facilitate growth. Stop the pure gambling
> environment that places bets on companies losing and plays losing
> and growth against each other in the sickness of hedging. Where
> did real, basic and honorable business go? It seems that our masters
> of business feel like they have to find ever new ways to distort
> finance in search of a trade commission or a sense of invention infected
> with layers of complication. They create default swaps and things
> that "derive value" rather than create value. It is sad that our
> financial talent has come to this meaningless sense of occupation.
> Who is teaching this? Their work now hurts the world instead of
> helping it improve, grow and produce real GDP. The MBA has become
> a Master of Bogus Activities seeking the next bonus for smoke and
> mirrors and products that mean nothing real, yet bring poison to
> honest enterprise and are truly an infection behind the weakend muscle
> of honorable work and productivity.
>> "We were promised in 2008 that the mistakes Greenspan made would not be repeated. We were told there would be more regulation on Wall Street with regards to compensation and financial instruments. We were lied to. " >> Great comment. Bernanke is son-of-Greenspin and keeping him and his fleet of helicopters at the fed will ultimately destroy the economy. Our economy was driven by the middle class. All fed policy rewards the wealthy at the expense of the middle class. The Fed is killing the middle class. "Jobless recovery" is an oxymoron.
Corporations are making profits by slashing employment. Every time a megabank swallows a local or regional bank, the pink slips fly. Same with other businesses. Long term, the results will be disastrous. And the Bernankes of the world coouldn't care less as long as the GS's of the world are making money.
On Aug 25 12:39 AM User 476509 wrote:
> I think all the above creates nothing of substance. These are people
> that assist each other's ego with toxic jargon that plays to a choir
> unified in a culture of meaningless finance driven by greed and self-import.
> They have in the last year unvieled to us a (their) culture of meaningless
> (poisonous) financial products and their unapologetic search for
> the next creative and dangerous wave of financial infection. For
> God's sake, stop it. Invest in support of simple "growth" as it
> should be ... and finance to facilitate growth. Stop the pure gambling
> environment that places bets on companies losing and plays losing
> and growth against each other in the sickness of hedging. Where
> did real, basic and honorable business go? It seems that our masters
> of business feel like they have to find ever new ways to distort
> finance in search of a trade commission or a sense of invention infected
> with layers of complication. They create default swaps and things
> that "derive value" rather than create value. It is sad that our
> financial talent has come to this meaningless sense of occupation.
> Who is teaching this? Their work now hurts the world instead of
> helping it improve, grow and produce real GDP. The MBA has become
> a Master of Bogus Activities seeking the next bonus for smoke and
> mirrors and products that mean nothing real, yet bring poison to
> honest enterprise and are truly an infection behind the weakend muscle
> of honorable work and productivity.
On Aug 25 12:27 PM axelrod608 wrote:
> Couldn't read the article through the ad overlay. SA's new format
> really sucks, but they are determined to keep it. Worst of all,
> they have no "contact" where you can complain to them about the many
> "bugs" in their new format. Clearly, SA doesn't want feedback.<br/>
All you need is one of these positions to double in order to lock in the profit. It is quite possible that they both would double at some point.