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Monday, July 13, 2009

Protect Financial Stocks with Cheaper Put Options

As recently posted in OptionMaestro.com, I believe the market will correct further, as a head and shoulders pattern has been formed (see here), which is a bearish sign. However as of Monday morning Meredith Whitney gave a rather bullish outlook on two of the larger financial stocks Goldman Sachs (GS), and Bank of America (BAC). It will certainly be a busy week for financial stocks, as Goldman Sachs reports Tuesday, and Bank of America reports Friday. Upgrading Goldman Sachs the day before earnings is an extremely good sign in my opinion, however we can't be too sure, so it may still be a good idea to purchase some put protection as a hedge against any long positions.

Monday would have been a great day to get into one/some of the option strategies I will outline below, as financial stocks soared. As I stated we can never be too sure what the market is going to do, so instead of trying to time the market by selling the stock and trying to buy it back at a lower price, a good way to protect your portfolio is to purchase PUT options for protection. A lot of people don't bother with put options because they are expensive, and if the stock rallies 100% of the premium paid for the put option can be lost. However, if you're like me and think that protection all the way down to $0 is unnecessary (for a shorter time period), you may find the strategy in this post useful, as it will allow you to purchase put protection for a cheaper price.

In this article I will talk mainly of financial stocks, as I believe if the market corrects further, these financial stocks will suffer the most, as they've experienced the largest gains since the market bottomed in March. The table below shows how much each of the following financial stocks have increased since March 6.

(all data in this post is as of market close Monday July 13, 2009)

Company March 6 Low July 13 Close % Change




American Express 9.71 24.52 152.52
Bank of America 3 12.99 333.00
Bank of NY Mellon 15.67 28.53 82.07
BB&T 12.9 21.86 69.46
Capital One 7.98 21.86 173.93
Citigroup 1 2.78 178.00
Fifth Third 1.23 7.16 482.11
Goldman Sachs 73.25 149.44 104.01
JP Morgan 14.96 34.71 132.02
Keycorp 5.07 5.38 6.11
MetLife 11.37 29.39 158.49
Morgan Stanley 16.7 26.15 56.59
PNC Financial 16.2 37.94 134.20
Regions Financial 2.76 4.07 47.46
State Street 17.34 46.53 168.34
SunTrust 8.76 16.24 85.39
US Bancorp 8.06 17.69 119.48
Wells Fargo 7.8 24.8 217.95




Average % Change

150.06


As you can see the basket of financial stocks above have increased on average 150% since March 6, 2009; the S&P 500 has increased just over 35%.

As I stated earlier, chances are you won't need protection all the way down to $0, so one way to get into put options for less money is selling a lower put (known as a bear put spread).

Therefore, this post requires the knowledge of stock options, as I'll be talking about opening up a Bear Put Spread option position on each of the stocks listed. If you need help understanding options, or to learn more about opening up one of these positions (and options in general) click here.

The puts purchased/sold in this post are for the August option expiration. The put being purchased is the strike price lower and closest to the current share price, and the put being sold is the next highest put available (below the put being purchased).

Bear Put Spread Option #1: Buy the American Express (AXP) August 24 put and sell the August 23 put. This strategy would cost $44 per contract to open, and gives you protection starting at 24 down to 23 until August 22, 2009. The current options market is factoring in a 32.3% chance you'll need at least this much protection (probability American Express will expire at or below 23 a share) by the August 2009 option expiration.

Bear Put Spread Option #2: Buy the Bank of America (BAC) August 13 put (currently in the money by $0.01) and sell the August 12 put. This strategy would cost $55 per contract to open, and gives you protection from 12.99 down to 12. The current options market is factoring in a 32.9% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #3: Buy the Bank of NY Mellon (BK) August 28 put and sell the August 27 put. This strategy would cost $42 per contract to open, and gives you protection from 28 down to 27. The current options market is factoring in a 36.1% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #4: Buy the BB&T (BBT) August 22 put (currently in the money by $0.14) and sell the August 21 put. This strategy would cost $48 per contract to open, and gives you protection from 21.86 down to 21. The current options market is factoring in a 38.5% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #5: Buy the Capital One (COF) August 22 (ironically also $0.14 in the money) put and sell the August 21 put. This strategy would cost $47 per contract to open, and gives you protection from 21.86 down to 21. The current options market is factoring in a 38.8% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #6: Buy the Citigroup (C) August 3 put (currently $0.22 in the money) and sell the August 2 put. This strategy would cost $56 per contract to open, and gives you protection from 2.78 down to 2. The current options market is factoring in a 16.7% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #7: Buy the Fifth Third (FITB) August 7.50 put (currently $0.34 in the money) and sell the August 6 put. This strategy would cost $66 per contract to open, and gives you protection from 7.16 down to 6. The current options market is factoring in a 22.6% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #8: Buy the Goldman Sachs (GS) August 150 put (currently $0.56 in the money) and sell the August 145 put. This strategy would cost $245 per contract to open, and gives you 5 points to the downside starting at 150. The current options market is factoring in a 39.9% probability you'll need at least this much protection by the August 2009 option expiration. Note that on these higher priced stocks it may be worth selling an even lower strike than the one indicated (such as the 140 or even 135).

Bear Put Spread Option #9: Buy the JP Morgan (JPM) August 35 put (currently $0.29 in the money) and sell the August 34 put. This strategy would cost $51 per contract to open, and gives you protection from 34.71 down to 34. The current options market is factoring in a 42.1% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #10: Buy the Keycorp (KEY) August 5 put and sell the August 4 put. This strategy would cost $25 per contract to open, and gives you protection from 5 down to 4. The current options market is factoring in a 13.1% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #11: Buy the MetLife (MET) August 29 put and sell the August 28 put. This strategy would cost $42 per contract to open, and gives you protection of 3.4% starting at 29 a share. The current options market is factoring in a 36.6% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #12: Buy the Morgan Stanley (MS) August 28 put (currently in the money) and sell the August 27 put. This strategy would cost $45 per contract to open, and gives you protection from 27.91 down to 27 (currently $0.09 per share in the money). The current options market is factoring in a 39.7% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #13: Buy the PNC Financial (PNC) August 37.50 put and sell the August 36 put. This strategy would cost $70 per contract to open, and gives you protection from 37.50 down to 36. The current options market is factoring in a 36.2% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #14:
Buy the Regions Financial (RF) August 4 put and sell the August 2.50 put. This strategy would cost $35 per contract to open, and gives you protection of 37.5% starting at 4 per share. The current options market is factoring in a 4.3% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #15: Buy the State Street (STT) August 46 put and sell the August 45 put. This strategy would cost $43 per contract to open, and gives you protection of 2.2% starting at 46 per share. The current options market is factoring in a 39.6% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #16: Buy the SunTrust (STI) August 16 put and sell the August 15 put. This strategy would cost $43 per contract to open, and gives you protection from 16 down to 15. The current options market is factoring in a 32.6% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #17: Buy the US Bancorp (USB) August 17 put and sell the August 16 put. This strategy would cost $35 per contract to open, and gives you protection from 17 down to 16. The current options market is factoring in a 26.8% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #18: Buy the Wells Fargo (WFC) August 24 put and sell the August 23 put. This strategy would cost $41 per contract to open, and gives you protection of 4.2% starting at 24 a share (current stock is at 24.80 so it will need to drop 3.2% before your protected - if you want full protection buy an in the money put option for the 25 strike, it will cost more but will protect you now). The current options market is factoring in a 34.2% probability you'll need at least this much protection by the August 2009 option expiration.

Financial ETF Ideas:

Bear Put Spread Option #19: Buy the Financial SPDR (XLF) August 12 put (currently in the money by $0.19) and sell the August 11 put. This strategy would cost $43 per contract to open, and gives you protection from 11.81 down to 11 or 6.9% from current share price. The current options market is factoring in a 31.5% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #20: Buy the Proshares Ultra Financials 2X leveraged ETF (UYG) August 4 put (currently in the money by $0.19) and sell the August 3 put. This strategy would cost $34 per contract to open, and gives you protection from 3.81 down to 3 or 21.3% from current share price. The current options market is factoring in a 17.5% probability you'll need at least this much protection by the August 2009 option expiration.

Bear Put Spread Option #21: Buy the Direxion Daily Financial Bull 3X leveraged ETF (FAS) August 43 put and sell the August 42 put. This strategy would cost $50 per contract to open, and gives you protection from 43 down to 42. The current options market is factoring in a 37.9% probability you'll need at least this much protection by the August 2009 option expiration. With these extremely volatile leveraged ETF's I recommend expanding the spread (sell the 40 or even as low as the 39 strike put option).

A general rule I like to follow is to sell the put contract about 7%-15% lower than the strike price of the put contract I purchased (does not apply for more volatile stocks and leveraged ETF's). The reason I like selling the spread when hedging my portfolio is because it allows me to hedge for a cheaper premium, and although it gives me less downside protection, I believe it should protect the majority of the move lower if the market does correct.

These options expire on August 22, 2009; therefore the last trading day is Friday August 21, 2009. As you can see, on average the greater the protection the more expensive the contract is to open.

If you're more bullish/bearish you’ll want to adjust the strike price accordingly. If you’re even more bearish, sell a put much lower than the one purchased, or don't sell a put at all. The cost will be more expensive to open the contract, however the downside protection will be greater.

This strategy is a great way to hedge your portfolio. The reason option volumes have exploded over the past 5 years is because they are a great way to hedge your portfolio (see chart here).

If you want to protect your overall portfolio, you may find another strategy I've been using more useful. By using covered call option strategies on the double and triple short leveraged ETFs such as the BGZ, FAZ, SDS, and SKF, I am able to hedge as well. See more details here.


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