Warped, Frustrated Old Banks

Mr. Potter: [to George Bailey] Look at you. You used to be so cocky. You were going to go out and conquer the world. You once called me “a warped, frustrated, old man!” What are you but a warped, frustrated young man? A miserable little clerk crawling in here on your hands and knees and begging for help. No securities, no stocks, no bonds. Nothin’ but a miserable little $500 equity in a life insurance policy.
[Potter chuckles]
Mr. Potter: You’re worth more dead than alive! [link]

The George Baileys of the world may be struggling this year, but so are the Mr. Potters.  The KBW Bank Sector index (BKX) tracks 24 major national and regional banks on a cap-weighted basis.  The conventional wisdom is that any genuine and sustained rally will include participation from the banks.  But over the past several trading sessions, the index has underperformed the S&P 500, and we expect that relative weakness to continue. We expect implied and realized volatility in BKX (pictured) to converge, but it’s anybody’s guess whether that will be via declining realized volatility, rising implied, or both.  The technical picture suggests that the 49-51 range may act as a key pivot: it acted as support in mid-July and mid-October and as resistance in early December, so that’s certainly an area to watch.

If you think BKX will be flat-to-down at January expiration, here are some ways to express that view:

  1. Long puts: the BKX Jan09 45 puts can be had for about $3.90, with a 77% implied volatility.  Buying these puts will get you long vega, which will look really smart if the underlying falls and implied volatility pushes up toward its recent highs.  Conversely, if the index languishes or even rallies, you’ll feel like you overpaid for the options.
  2. Short call vertical: the BKX Jan09 50/52.5 call vertical will net a credit of about $0.65.  Of course, this expresses the same bearish directional view but with a short vega stance.  That means that if BKX does rally against you, falling implied volatility will lessen the blow to some degree.  By choosing strikes in that 50-52 range, we can also set our breakeven point for the trade near or above the pivot area we discussed.
  3. Long put butterfly: the BKX Jan09 35/45/55 put butterfly is priced at about $3.95.  This is also a short vega trade, but it’s relatively delta neutral, which means that the trade will make money as long as the underlying is roughly between 39 and 51 at expiration, with the largest profits occuring if BKX trades sideways.
  4. Short iron condor: the BKX Jan09 30/35/55/60 iron condor will net a credit of about $0.90, with breakeven points around 34 and 56.  Traders who follow our iron condor newsletter already know the advantages of these sorts of trades.

There’s an ETF that tracks this index (KBE), but the options there aren’t very active, so you’re probably better off sticking with the slightly more active BKX listings.  Some readers may wonder why we haven’t opted for the far more active Financials ETF (XLF): the reason is that XLF also includes a lot of insurers, exchanges, i-banks, etc. etc. and we wanted a purer play on commerical banks.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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