Option Strategies From The Stress Test

|
Includes: AXP, BAC, BBT, BK, C, COF, FITB, GS, JPM, KEY, MET, MS, PNC, RF, STI, STT, USB, WFC
by: Value Research

The stress test results recently released by the Federal Reserve have created an exploitable risk measure which can be used to inform options trades. This alternative risk measure will serve as a counterpoint to share price volatility, which is often used to estimate credit risk in financial stocks. By moving away from volatility as a risk metric, attractive option-plays can be identified.

The Federal Reserve's stress test was more like a disaster test because it assumed 13% unemployment, a 50% drop in equity prices, and a 21% decline in housing prices. All things considered, their models illustrated that many banks fared very well:

Ticker

Company

Stress Scenario Tier 1 Capital Ratio

Beta

Volatility (Month)

P/B

STT

State Street Corp.

15.1%

1.39

0.0232

1.1

BK

The Bank of New York Mellon

13.3%

0.84

0.0216

0.8

AXP

American Express Company

12.4%

1.83

0.0163

3.4

FITB

Fifth Third Bancorp

7.7%

2.17

0.0238

1.0

USB

U.S. Bancorp

7.7%

1

0.0189

1.7

BBT

BB&T Corporation

7.3%

1.04

0.0194

1.2

COF

Capital One Financial Corp.

7.2%

1.73

0.0192

0.8

PNC

PNC Financial Services Group

6.6%

1.21

0.0185

1.0

WFC

Wells Fargo & Company

6.6%

1.32

0.0211

1.3

JPM

JPMorgan Chase & Co.

6.3%

1.25

0.0223

0.9

KEY

KeyCorp

6.3%

0.84

0.0254

0.8

C

Citigroup, Inc.

5.9%

2.56

0.0281

0.6

GS

The Goldman Sachs Group

5.8%

1.42

0.0244

0.9

BAC

Bank of America Corporation

5.7%

2.27

0.0274

0.4

RF

Regions Financial Corp.

5.7%

1.48

0.031

0.4

STI

SunTrust Banks, Inc.

5.5%

1.46

0.029

0.6

MET

MetLife, Inc.

5.4%

1.94

0.0211

0.7

MS

Morgan Stanley

5.4%

1.53

0.0313

0.6

We can use these projected capital ratios generated from cataclysmic modeling to quantify bank risk. Higher tier 1 capitalization ratios bode well for a bank being able to whether financial hardship based on its current (as of first quarter 2012) capital structure. Lower capital ratios demonstrate how a bank might need to raise capital before its peers with higher projected capital ratios.

Bank stock volatility was then plotted against these capitalization ratios:

Volatility vs. Stress Test Capitalization Ratios
(Click to enlarge)

This is an incredibly useful plot which enables risk-adjusted option analysis. Typically the go-to model for financial company credit risk would be the Merton Model, which utilizes stock price volatility as an input. Higher volatility would result in higher risk forecasts. Since Black-Scholes-Merton option pricing also uses volatility as an input, risk and reward move together in lock-step. Such a scenario precludes risk-adjusted outperformance from taking savvy positions.

Fortunately, the stress test has given us a second measure of risk. This plot can be scanned to find where the volatility seems low relative to the risk of the firm. Such points will be to the lower left of other data points, and would be the most promising long put candidates of the financial companies featured in the stress test. MetLife and PNC Financial Services Group are at the lower left of the scatter plot, and both stocks have markets for long-dated options.

This plot can also be used to find where volatility is high relative to risk assessed by the stress test. Such stocks would be interesting covered call or short put candidates, and would appear in the plot at the upper right of the curve. State Street and The Bank of New York Mellon appear to the far right of the other data points, and have higher volatility than American Express. Hence, options on STT and BK shares seem richly priced by comparison. There are liquid markets for long-dated options for both stocks.

The latest stress test has been very useful in evaluating risk based on fundamentals-driven scenario analysis. Though the scenario itself is extreme, this modeling process and its outputs provide direction in finding interesting option plays in an opaque sector.

Please read the article disclaimer for this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.