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Thursday, August 13, 2009

Are Financial Stocks Especially Overpriced? Some Protective Ideas

As I recently wrote on OptionMaestro.com, I believe the bank stocks are especially overpriced, but don't really want to sell all of my shares (as this stock market could continue rallying). In this post there are two types of hedging or protective ideas that require the use and knowledge of stock options. To learn more about the risks, pricing, calculations, strategies, and options in general click here.

My major reason for taking a protective stance on the financial stocks is because they have risen the most since the March 2009 stock market bottom (they also fell the furthest in the market massacre - which is one of the reasons I'm taking these option approaches versus selling all of my shares). The Google Finance chart below shows some of the very popular SPDR ETF's and their performance since March 6, 2009 (click image to enlarge).

As you can see the Financial Select Sector SPDR has outperformed the other 5 in the same chart by at least 50%.

As I've stated in several blog posts, I believe if we get some sort of market correction the financial stocks [sector] will suffer the most, simply because they are overbought compared to the other sectors. As stated in Sell Off Ahead? 25 Ways to Profit and Protect from a Stock Market Correction, I still believe we may see a pull back on the major indices within the next month.

Strategy #1: Using Put Options Open a vertical Put Spread. This will allow you purchase put options for cheaper, but also limits the downside protection on the stock. I chose the October, November and December options expiration (depending on the underlying stock's option cycle), which will provide 65, 100, and 128 days of protection respectively. Many people try to use the Leveraged Index ETF's such as SDS and BGZ as a means of protection, but increased swings (volatility) will cause these vehicles to decay (see more here). Opening this strategy on these stocks isn't free, but I believe it is a better way to hedge than purchasing leveraged ETF's.

All data as of market close Wednesday August 12, 2009.

Understanding Table #1:
Month: This is the month both option contracts expire; O = October, N = November, and D= December.
U Strike: This is the upper strike or the put contract which is being purchased.
L Strike: This is the lower strike or the put contract being sold against the put contract which was purchased.
Protect: This is the amount of protection the position provides once the share price falls to the upper strike price (in %).
Net Cost: This is the amount that must be paid in dollars per share to open this position.
Saved: This calculation shows how much less the position will cost by making it a vertical spread versus a traditional put position (in %).

Company Ticker Month U Strike L Strike Protect % Net Cost Saved %
American Express Company AXP O 30 24 20.00 1.50 26.83
Bank of America Corporation BAC N 16 12 25.00 1.37 26.74
Capital One Financial Corp. COF D 32 24 25.00 2.55 36.25
Citigroup Inc. C D 4 3 25.00 0.40 40.30
Goldman Sachs Group, Inc. GS O 160 130 18.75 7.15 20.56
JPMorgan Chase & Co. JPM D 40 30 25.00 2.30 23.33
Morgan Stanley MS O 29 23 20.69 1.55 24.39
Regions Financial Corporation RF N 5 4 20.00 0.51 46.32
The Bank of New York Mellon Corporation BK D 27 20 25.93 1.80 21.74
Wells Fargo & Company WFC O 26 21 19.23 1.30 31.58

If the market continues to rally and the puts expire worthless, the premium [cost] paid for the option contract will be completely lost. Most of the option spreads are not yet in the money, meaning the stock can pull back without the position being hedged. If however the market sells off and the stock falls below the higher strike price, the position will be protected until the lower strike price (% protection).

Strategy #2: Sell calls against the stock. This will allow the shareholder to receive a premium instead of paying it like the example above. The table below is for ext highest strike call option for the September options expiration. This strategy allows the position to return additional profit as well as providing protection. A worded example follows for interpreting the table directly below it. For return % purposes, the example assumes the stock was purchased and written as of market close Wednesday August 12, 2009.

Purchase American Express (AXP) stock, and sell the September 32 strike call option. The premium received from the call option would give a downside protection of 5.97%. If the stock is assigned at options expiration on September 19, 2009 the total return from this position would be 6.60%.

Company Ticker Strike Protection % return %
American Express Company AXP 32 5.97 6.60
Bank of America Corporation BAC 16 6.28 6.72
Capital One Financial Corp. COF 34 7.25 7.87
Citigroup Inc. C 4 8.54 9.05
Goldman Sachs Group, Inc. GS 165 3.91 4.67
JPMorgan Chase & Co. JPM 42.5 4.71 5.40
Morgan Stanley MS 30 5.77 5.84
Regions Financial Corporation RF 5 7.88 11.62
The Bank of New York Mellon Corporation BK 29 4.88 5.89
Wells Fargo & Company WFC 28 4.67 7.73

As you may have noticed, the less volatile the underlying stock, the less the option premium is (return and protection percentages). Based on this analysis of 10 stocks, the stocks which offer the greatest combination of both potential return and protection are: Citigroup Inc. (C), Regions Financial (RF), and Capital One (COF). As a shareholder of American Express, Bank of America, and Goldman Sachs, I will be using this strategy to write my shares out. However I am a very active trader and will look to write them out for the August options expiration as well. To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here.

To reiterate a previous blog post: As the Volatility index is creeping back up, call option premiums should increase in value overall, protecting and giving an even higher return. I use this strategy to write my shares out on strength, and purchase them back on weakness (if I am profitable).

For example: using this strategy has allowed me to cost average my position on Caterpillar (CAT) down to $4.88 a share. Patience is key to succeed with this strategy. If the stock gets called out, and you miss the upside, the position is still profitable and you can always use the buy/write option strategy [if you're still bullish] to purchase the stock and generate the income for the following month's option expiration. If the stock gets hammered and you're down on the position, this strategy will keep you in the game and allow you to cost average the shares down month after month.

This strategy will give protection if the market sells off, as well as provide a return if the market continues to rally. If the stock is not assigned, this strategy is a great way to create additional income for your portfolio. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

All ideas outlined in this article are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

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