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Wednesday, August 26, 2009

Banking on the Banks to Move: Detailed Option Strangle Strategy

With banks continuing to demonstrate strength throughout the month of August, many have been anticipating a sell off to come soon. I too have been anticipating the banks to sell off, but lately they've made a fool of me. Let's face it, this rally could continue for quite a while with all the money sitting on the sidelines. In this article I will outline an option strategy which I'll be opening for the September options expiration, as it returned a great amount of profit for the August options expiration (and I was anticipating a rather calm stock market).

To begin I will show the change for ten of the major financial stocks since the stock market bottom in early March. The table below shows the % change for three time periods following the market bottom: 1 month following the market low, 3 months following the market low, and market bottom to August 25, 2009 (Bottom to Date)

Date used for market low was March 6, 2009.

Company Ticker 1 Month 3 Month BTD
American Express Company AXP 46.75 141.53 217.71
Bank of America Corporation BAC 135.96 274.12 459.93
Citigroup Inc. C 166.66 139.21 365.68
The Bank of New York Mellon Corporation BK 43.31 43.6 49.57
Morgan Stanley MS 26.64 72.25 67.9
Wells Fargo & Company WFC 87.81 204.4 236.58
JPMorgan Chase & Co. JPM 69.87 108.12 162.53
Goldman Sachs Group, Inc. GS 42.74 82.34 101.84
KeyCorp KEY 41.78 -3.04 15.71
Regions Financial Corporation RF 36.45 29.03 88.06

As you can see the rate of acceleration has slowed (not only for financial stocks but many stocks). Most of the financials experienced their largest gains during the first month following the market bottom (March 6, 2009 - April 6, 2009). However from the next table below, we can see financials were not asleep during the month of August.

Company Ticker August % Gain
American Express Company AXP 15.84
Bank of America Corporation BAC 20.01
Citigroup Inc. C 49.84
The Bank of New York Mellon Corporation BK 7.50
Morgan Stanley MS 5.92
Wells Fargo & Company WFC 11.73
JPMorgan Chase & Co. JPM 12.75
Goldman Sachs Group, Inc. GS 1.00
KeyCorp KEY 12.10
Regions Financial Corporation RF 31.89

I strongly believe increased activity will return to the stock market after labor day, causing a large move upward or downward, so I assume financial stocks will either continue to rally greatly or sell off sharply. With this date approaching, I am anticipating a big move again either lower or higher. The strategy I will outline will profit if such a move happens. The way I plan on capturing a move in either direction is by using the option strangle strategy. I plan on doing this by opening a strangle on one of the most volatile financial ETF's available, the Direxion Daily Financial Bull 3X ETF (FAS). To learn more about option strangles, risks, pricing, calculations, other strategies, and options in general click here.

The Trade:

I am anticipating a drop in the financials by September options expiration, but as stated before they could keep rallying; if they do continue to demonstrate great strength this option position will also profit. To make this trade I will choose a near the money option put option. I am thinking the 75 strike Put option (delta -0.389). In case the financials continue to strengthen over the next 24 calendar days, I will also purchase a call option with a similar delta. This happens to be the 84 strike call option (delta 0.40). This strangle would cost me roughly $1000 per option contract.

In order to break even from this strangle, the FAS would need to increase by 20.95% or decrease by 16.37% from close price Tuesday August 25. Anything above or below those levels will result in a profit. Note that this is an extremely risky strategy and should only be used if one believes financial stocks will experience a great amount of volatility, resulting in an increase or decrease above or below these levels. 100% of the position will be lost if the FAS expires anywhere in between the two strike prices ($75 - $84). I opened a similar strangle on FAS for the August options expiration on July 31, 2009 and the FAS increased by 34.5% by options expiration, however as I rarely wait until expiration, I closed my position within one week (August 7) for a very nice profit.

I will be looking at opening this position on decreased levels of implied volatility, one of which I assume will be sometime after the new home sales data is released on Wednesday August 26 at 10 AM.

The ideas outlined above involve the use of stock options. 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 option volume chart).

These 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.

Disclosure: Long AXP, BAC, GS, FAS, Short BAC September 18 Calls, GS September 180 Calls, FAS September 85 Calls

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2 comments:

DennisM said...

I have been following your blogs for a couple of weeks. Tried some of your strategies and like them. You talked about GOLD a while back buying LEAPs and selling cals against them. What do you think about AAPL JAN 2010 deep ITM call for 130 and selling calls against it? Like SEP 175.

Marco H said...

Sounds like a nice idea if you plan on trading in and out of the upper strike. What would be the % profit if Apple expired in the money?

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