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Wednesday, September 2, 2009

Financial Stocks Over Heated? Protect with Diagonal Put Spreads

Many financial stocks have been in the spotlight in the past week, as rumors have caused them to sky rocket. I am sure you are quite familiar with them, as you've read about or watched their ticker symbol scroll by, but to mention four of them they are: American International Group (AIG), Citigroup (C), Fannie Mae (FNM), and Freddie Mac (FRE). Citigroup has not rallied nearly in step with the other three mentioned over the past week, but has had a much later rally than many of the other large financial names.

I am very skeptical of these names climbing so fast recently, and although I don't usually purchase and hold put options overnight (or call options for that matter, I use them frequently but usually trade out of them by market close), I have made an exception as I have purchased put options for American International Group (AIG) for the September 45 strike. I am bearish on the financial stocks in the short term, but extremely bearish on AIG. I am expecting a continued sell off, and I think a sell off will hit the financial sector the hardest as mentioned in Are Financial Stocks Especially Overpriced? Some Protective Ideas.

Financial stocks; too fast
, too soon?

Looking at the first Heatmap below, we can see that financial stocks are up more on average than any other sector in the past month (and the most since the market bottom in early March - not shown). The majority of the box is the brightest level of green (the brightest level green indicates a 6% or greater increase in the stock, and the brightest level red indicates a 6% or greater decrease in the stock. See the Heatbar below the first Heatmap to get a detailed definition of colors % gain or loss). I have highlighted one of the larger market cap stocks JPMorgan Chase (JPM) to give an idea of how to read the Heatmap. The map is comprised of many different stocks, the larger the box the greater the market cap. As you can see JPM is just one of many stocks which traded higher than 6% in the past month from the financial sector.

(click all images to enlarge)

The second Heatmap below is a zoom in of the financial sector, and although it may look like only a few different financial stocks (due to identical colors), it is the entire financial sector (stocks included are the financial stocks which which have options available to trade). I have highlighted Bank of America (BAC) to show just one stock which is up greater than 6% in this period.

We can see the financials are extremely over heated on a 1-month basis, so if the market continues to sell off, I believe the financials will suffer the most. The strategy below will certainly help hedge against any financial positions or can be used as an all out speculative play if one is very bearish on the financial sector. The strategy below requires the knowledge of stock options, to learn more about this strategy, risks, pricing, calculations, other strategies, and options in general click here.

The Trade:

I have opened a diagonal put spread using the Direxion Daily Financial 3X Bull (FAS). I purchased the January 70 strike put options and immediately sold some October 50 strike put option against them. The January 70 Put option contracts were $1,800 a piece, and the October 50 strike put option contract was trading for $265 per contract (at the time of sale) making this spread net long $1,535 per contract.

Possible Outcome:

If the financial sector continues to sell off resulting in FAS to be at or below 50 at October options expiration, this position will help hedge my financials by returning 30.3%. If FAS does not trade below this level at October options expiration I will sell a similar put contract for the month of November. I have some Januray put option contracts which I have not completed a diagonal put spread on, but will look to do so on continued weakness, perhaps even for the September options expiration.

I am long several financial stocks, therefore using this strategy will help me hedge against a sell off. I feel this is a much better strategy than going long the the Direxion Daily Bear ETF's such as the FAZ or BGZ, as increased levels of volatility cause these funds to decay over time as blogged about here. The FAS is a very hard ETF to sell short for this reason (decay), therefore premiums may be a bit overvalued at times. Longer dated put options on the FAS tend to hold their value compared to longer dated call options on the Direxion Daily Financial 3X Bear (FAZ), once again because they decay with increased levels of volatility.

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 AIG September 45 Put options, BAC, C, FAS January 70 Put options, Short BAC September 19 Call options, C September 5 Call options, FAS October 50 put options

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