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Friday, September 11, 2009

Banking on Volatility to Spike: Time to Buy Put Options on Financials?

In this post I will compare some put options amongst some of the most actively traded financial stocks, which will benefit the most from rising market volatility. With the market rallying and volatility sinking like a stone lately, now may be a good time to get long some put options which will benefit from both a sell off as well as rising volatility. Let's face it, there's still a lot of uncertainty going forward, so with the Volatility Index [VIX] at these levels, I believe it is a good time to buy put options. With some negative news we could see a real spike in volatility, I believe it is bound to get back above 30 short-term. In my opinion purchasing in or at the money put options on financial stocks is a better way to hedge versus purchasing expensive out of the money call options on the VIX.

As you can see from the chart below of the S&P 500 (top half) and Volatility Index (bottom half), the VIX bottomed out at 22.58 on August 25, 2009, but the S&P 500 has traded higher since.

I believe the VIX will have a tough time getting below the 22 range. If it cannot break through it and hold, I believe we could see the VIX move higher short-term. The reason I chose to use put options on the financial stocks, is because they are the best performing sector since market bottom, and I believe if we get a short-term correction causing the volatility index to increase, financials will suffer the greatest, meaning put options on financial stocks will benefit not only by the price decrease of the underlying, but also the rising implied volatility.

The table below lists October put options on six major financial stocks, the implied volatility (which will increase as market volatility increases), Vega, and the Vega as a % of the premium.

Company Ticker Strike Implied Vol. Vega % of Premium
Bank of America BAC 17 52.043 0.022 2.18
Citigroup C 5 68.253 0.006 1.07
Goldman Sachs GS 175 33.967 0.221 2.87
JPMorgan JPM 43 39.648 0.054 2.50
Morgan Stanley MS 29 44.936 0.036 2.00
Wells Fargo WFC 28 44.398 0.035 2.06

If the VIX creeps back up and implied volatility on the stocks mentioned above also starts to increase, the two put contracts that will benefit the greatest are the Goldman Sachs (GS) October 175 put contract, and the JPMorgan (JPM) October 43 put contract (based on current levels). However they are more stable financial stocks and if volatility rises or we get a short-term sell off they may not suffer as much as the other financial stocks listed. With volatility approaching a 52 week low and as a shareholder of Goldman Sachs and Bank of America (BAC), I chose to purchase put options to protect my shares as protection is flat out cheap.

If you're like me and don't like the idea of spending a lot of additional money to protect your shares, perhaps you may want to look at writing a covered call, or using a put option spread like the two outlined below. Put spreads are great because they allow you to protect for cheaper, however they limit the protection. To learn more about the option strategies outlined in this post, risks, pricing, calculations, other strategies, and options in general, click here.

Below are two examples of put option spreads that can be used for the month of October on the two stocks from the table that have the highest levels of implied volatility (excluding Citigroup (C) due to very limited strike prices): Morgan Stanley (MS), and Bank of America (BAC).

Bank of America Put Option Spread: Purchase the Bank of America October 17 strike put option and sell the October 15 strike option against it. Making this a spread versus just purchasing a put option to protect will lower the cost of the position by almost 37%, while protecting Bank of America shares 11.8% if the stock happens to sink below 17. This position can be opened for $64 per option contract or 3.7% of the current share price (3.8% of the strike), which is relatively cheap considering it provides over 1 month of protection on Bank of America down to 15 a share, and these bank stocks could easily gain or lose that in a single trading day.

Morgan Stanley Put Option Spread
: Purchase the Morgan Stanley in the money October 29 strike put option and sell the October 25 strike option against it. Using this spread would lower the cost by 27.8% versus purchasing just a put option, while protecting 12.7% from the current share price. This position would cost roughly $130 per contract or 4.54% of the current share price to protect Morgan Stanley shares down to 25 a share over the next 35 days.

I am taking advantage while the VIX is approaching a 52 week low to purchase put protection.
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 BAC, C, GS, BAC September 16 Put Options, BAC October 17 Put Options, GS October 175 Put Options, Short C September 5 Call Options, BAC October 14 Put Options, GS October 160 Put Options

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