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Daily Stock Market Equity and Options Trading Commentary

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Monday, October 5, 2009

Bank some Profits from a Sell Off using Direxion's Financial Bull ETF (FAS)

As posted in Charting the banks on OptionMaestro.com, I was once extremely bullish on the financial stocks. Most of the targets which were unheard of back on May 10, have either been hit or passed. I am currently bearish short term; I believe we will see profits taken over the next month which would cause these financial stocks to move lower. In this article I will describe a way which I have been using (and will continue to use) to capture the downside on the financial sector. To understand the trade described in this article, you'll need a background of trading stock options. To learn more about the option strategy that will be outlined in this article, risks, pricing, calculations, other strategies, and options in general, click here.

Why the financial sector? I chose the financial stocks because they are up the greatest % since the market bottom, and if this sell off continues, we may see the financial stocks suffer the most. The table below shows the performance of 10 financial stocks since March 9, 2009 (closing low on the S&P 500). Stocks are ranked in order from greatest % gain to least. I used data from Google Finance, so I know everyone has access to it as well.

Company Ticker Current Close March 9 Close % Change
Bank of America Corporation BAC 16.34 3.75 335.73
Citigroup Inc. C 4.52 1.05 330.48
American Express Company AXP 32.49 10.64 205.36
Wells Fargo & Company WFC 26.28 9.97 163.59
JPMorgan Chase & Co. JPM 41.86 15.9 163.27
Goldman Sachs Group, Inc. GS 179.61 73.95 142.88
SunTrust Banks, Inc. STI 21.15 10.09 109.61
Morgan Stanley MS 29.46 16.48 78.76
The Bank of New York Mellon Corporation BK 27.6 18.02 53.16
KeyCorp KEY 6.17 6.06 1.82

To show a chart of these stocks over this period, I also generated a chart from Yahoo Finance which can be viewed below (click chart to enlarge).

All the stocks happen to be positive during this period, with KeyCorp gaining the least and Bank of America gaining the most.

In my opinion the safest way to trade the downside of these stocks is either going short the Direxion Daily Financial Bull 3X ETF (FAS) or buying at/near the money put options on the FAS. As described in Double and Triple Leveraged ETFs Revisited: The Real Decay, we can see that increased levels of volatility cause these instruments, such as the FAS, to decay. For this reason it is extremely difficult to find shares to short, which makes the put option trade a bit more attractive for liquidity reasons. If you are bearish on the financial sector or would like to hedge some of your holdings you may find the trade outlined below helpful.

The FAS Trade:
Using a vertical put spread will limit the amount gained on the downside, but is cheaper than purchasing just put protection (however I recommend just put protection for someone who is all out bearish on financials). With the FAS near 72 a share, it would be worth looking at the 72/67 put spread. This can be opened by purchasing the October 72 put options on the FAS, and selling the October 67 put options against them (same number bought and sold). Using Friday's close price, one could purchase the October 72/67 vertical put spread for $220. If the financial stocks continue lower, resulting in the FAS to close at or below 67 a share on October options expiration (October 17, 2009), this position could be closed for $500 or a gain of 127%.

A more bearish approach would be to look at opening a 72/64 vertical put spread. This spread could be opened for $320. If the FAS closed at or below 64 a share on October expiration this position would be closed for $800 or a gain of 150%. I choose this strategy over the Direxion Daily Financial Bear 3X ETF (FAZ) because it also suffers from volatility decay. Note the risks involved with this trade, because if the FAS moves higher or sideways over the next 10 trading days, 100% of the cost per spread can be lost.

To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here. As a shareholder of American Express, and Bank of America, I have my portfolio hedged using this strategy. I believe we could see the S&P 500 trade down to the 975 area in the short term, before we rally higher. I will look to start closing positions if and when the S&P 500 nears the 1000 range, and use weakness to continue closing my spreads.

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.

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).

I dedicate this post to my father, who passed away 5 years ago today.

Disclosure: Long AXP, BAC, FAS October 73 Put Options, FAS October 67 Put Options, FAS November 65 Put Options, Short FAS October 65 Put Options, November 55 Put Options

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1 comments:

Anonymous said...

Marco,

Besides the resistance levels that you used in the May charts, and the puts being placed in the financials in the largest options contracts being traded last week, what other resources are you using to look at when assessing the financials at this juncture? Are you using any other technical indicators? Thanks for your insight.

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