Two Ways To Gain Exposure To Financials With Less Risk - Guest Post

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Source: Flickr (yuan2003)
Guest post by JBL

Do you own financial stocks or are you thinking about buying financial stocks because they have been hit so hard this year???

Here are 2 ways to gain some exposure to financials with less risk than just buying your favorite bank’s stock outright.

The first is a dispersion trade of sorts where you would sell the XLF, which is the S&P Financial Sector ETF, and buy a basket of 5-10 financial stocks that you think are healthy companies. The idea being that we all know the financial sector is not healthy, interest rates are at record lows limiting banks earning potential, and investment banks (most of which get more than 50% of their revenue from trading operations) have had to cut back trading operations due to Dodd Frank. So by getting short the sector as a whole and going long what you believe to be the healthiest banks aka the banks that will outperform this year, you create a long/short trade that at worst should break even over the course of the next year, and that seems like a pretty good floor considering the market's current performance.

The second idea, using Morgan Stanley (MS) as an example, which closed today October 6th 2011 at $15.18. 100 shares of Morgan would cost $1518.00. Now rather than use my $1518 to buy stock in a company that according to the company's credit default swaps (CDS) has significant risk of going bust, I would rather sell a put option on MS. Personally I would sell the 13 put expiring Nov 19, 2011, which closed today around $1.05. This means that if at expiry MS was trading at or below 13, I would have to buy 100 shares for $13.00, but I would have collected $1.05 per share in option premium lowering my entry price to $11.95. If MS were to close above $13.00 I would collect the full $105 in premium, and my $1518 is now $1623 for a 6.9% return over just a 40 day period. You could potentially collect between 4%-8% per month. If you averaged 4% per month that would earn you about $700 on the year for almost a 50% return. For this to happen, MS would have to never trade through your strike at expiry, however if you did end up getting exercised on your short put options you could turn around and sell a call option (covered call strategy), an example being the 18 Call expiring Nov 19 that trades for about 60 cents or 4% of the stock price. No trade is a guaranteed winner, but over time a proper option writing strategy should outperform a buy and hold strategy. See the CBOE white papers on the Buy Write Index (BXM) and Put Write Index (PUT) for more information on how these strategies could help your portfolio.

Comments

  1. The sell to open option trade strategy is one of the simplest investment plans around, yet it gets very little exposure in the finance media. Probably because a person with some common sense can guide themselves, without depending on an expensive newsletter. I've been using this strategy for a few months, and done ok. I've learned several important issues in this field that a little article of explanation somewhere could have saved me time and grief. My advice from this perspective is to deadpan the hype in the media, just look at the news to get the gist of current trends, by using the many free investing internet sites, such as this one. Also, you need a spreadsheet to plan your options trades for optimum yield and safety. Lastly, the biggest clue: Never mind what the stock is, go for the high-value, high trade-volume options.

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  2. The sell to open is a great play, the way the market moves up and down these days, you are most likely going to get exercised on your puts eventually, you may as well collect some of the premium until it happens. and if you like the stock when its trading $25, selling the 25 put for $1 drops your entry price to $24, you have to really like the stock at $24 right?  So what if you don't get the stock right away you could be getting 4% per month!  there are millions out there that would be happy to get 4% per year give the last decade.  Adding covered call selling to your portfolio is also a good move.  We run a similar strategy for our clients, it lowers the volatility of their portfolio, provides them with income, they are thrilled to maintain their long only exposure and be up year to date.

    Agree with Ombudsman that adding a spreadsheet to the mix helps planning your trades and makes it easy to  break out which stocks yield the most for options selling.

    would add that people should check premium yield they are receiving vs the equivalent SPY option (by equivalent I mean strike as a percent of underlying), if you are getting less than the SPY its probably not worth selling that option, as its very rare that a individual equity is less risky than an index.
      

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  3. This is also interesting. Dominic Chu (@The_Domino) of Bloomberg tweeted this on Oct 7.
    "Goldman Sachs advises clients to buy the Oct $16 call options on Morgan Stanley stock & sell short dated CDS $$ $GS $MS "#optiontradinghttps://twitter.com/#!/The_Domino/status/122304878268784640

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