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Wednesday, May 13, 2009

Banking on Financials with Limited Risk

Want to buy financials, but don’t dare due to fears of a company filing bankruptcy, getting nationalized, etc...? Want to short financials, but find yourself afraid that the market will rally?

Well, a strategy that has made me "bank" is playing the spread on ETFs. I don't recommend playing leveraged ETFs for the long run, but looking up to 3 months ahead, and depending on the downside risk, I may take the risk.

In March this strategy returned me 212%, and in April it returned 444%. I didn’t play the May expiration, as I thought the financials were overbought, but I estimate (based on Tuesday's closing price) that I missed nearly a 70% gain. So on with the strategy...

As I'm sure we'll create a hindsight bias in the months to come, (forward speaking) many individual bank stocks would have been good buys and many would have been bad buys. It’s just too bad we don’t have a crystal ball to tell us which ones to buy/sell now.

The best way I know of to have a chance at big gains with limited losses is outlined below.

There are two strategies: both a Bear Put Spread and a Bull Call Spread. Depending on where you think the ETF will be (in terms of dollars) and time frame, you may need to adjust expiration and strike prices accordingly. (All prices based on close price Tuesday May 12, 2009).

Some Ideas for the Bulls:

Spread Strategy # 1: Buy the XLF June $12 Call and sell the XLF June $14 Call. This strategy would cost $65 per contract to open, and if XLF can close above $14 at June expiration the profit from this strategy would be $135 or 208%. Break even point is the XLF at $12.65 come June options expiration.

Spread Strategy #2: Buy the UYG June $4 Call and sell the June UYG $5 Call. I opened this position on Tuesday May 11 for $40 per contract, but with some hard bargaining I think it could be opened for $30-$35 per contract. If UYG is above $5 come June expiration I will net $60 a contract or 150%. Break even is $4.40 per share at expiration.

Spread Strategy #3: Buy the FAS June $11 Call and sell the June $15 Call. This could be opened for roughly $100 per contract and has a potential of netting $300 if FAS closes above $15 come June expiration. The net profit in this case would be $300 or 300%. Break even is FAS at $12.

Spread Strategy #4: Buy the FAZ June $4 Put and sell the FAZ June $3 Put. This strategy can be opened for roughly $20 per contract and if FAZ closes below $3 at June expiration it will yield $80 profit or 400%. Break even is FAZ at $3.80.

Some Ideas for the Bears:

Spread Strategy #1: Buy the XLF June $12 Put and sell the June $10 Put. This would cost roughly $60 per contract to open, and if XLF is below $10 come June expiration the net profit would be $140 per contract or 233%. In order to break even on this play the XLF will need to be at $11.40 come June expiration.

Spread Strategy #2: Buy the UYG June $4 Put and sell the June $3 Put. To open this would cost roughly $30 per contract, and if UYG expires in June below $3 per share you’ll net $70 or a gain of 233%. Break even would be UYG at $3.70 at June expiration.

Spread Strategy #3: Buy the FAS June $9 and sell the June $5. This position could be opened for roughly $125, but I give it a larger spread due to the volatility on this (dangerous in my opinion) ETF. If FAS ends up below $5 at June expiration this strategy would have netted a $275 profit or 220%. Break even would be at $9.25.

Spread Strategy #4: Buy the SKF June $45 Call and sell the June $52 Call. This position could be opened for roughly $200 per contract and if SKF expires in June above $52 this strategy would net a profit of $500 or 250%. In order to break even SKF would need to be at $47 come June expiration.

I found the best strategy to be the single ETF or the XLF. Depending on how long you wait to implement these strategies will make a big difference, and each strategy should be fully analyzed before opening any of these spreads.




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