By Andrew Giovinazzi
Most of 2012 has been a bit of a roller coaster for the financial stocks. After starting the year off, along with most of the market, on a nice run, the buzz saw of Dodd-Frank, lower margins and a currency collapse put the bank stocks in a bit of a tizzy. What that has led to is very low valuations for the sector as a whole.
I cannot argue with that, but the expectation level is now about nil for the group. That is a good time to start digging around for some bargains. Using options, there are plenty of choices, and I prefer the Select Sector SPDR-Financial /zigman2/quotes/209660484/composite XLF -1.61% instead of trying to pick an outright winner among the individual names.
Think about the situation that confronts the XLF. Mostly, the worst is over in the financials, but as an investor, there is a need for protection. Also, look at how the XLF moves as a product. It does not move very much. As a matter of fact, I have the 180-day realized volatility for the XLF around 17.7%. This means the XLF is trading at the bottom in realized volatility. So you missed the rally in financials and you want to get on board at a lower price?
Now, with some of these conditions in mind, fashion a trade that fits the environment currently and for what you want for the next six months. How do you do that?
Let’s look at an example. The first step is to identify an out-of-the-money put for protection. The OIC did a study, and they like the six-month-out puts for a combination of theta and movement . Essentially, you don't want your protective put to decay too fast. For the XLF, the right candidate would be the June 14 put for .44 or so. The implied volatility is so low that this makes a great entry for protection. Against the long put in June, a trader needs the positive decay side.
For now, in this example, you would start with selling the XLF Jan 11 Weekly 16.5 level put for .28 or so. That puts the investor into the XLF for around $16.22, worst case. Now simply keep rolling the short put to the next month until you get to June. Since the XLF has new listed weekly options for five weeks, every week, there will be lots of puts to choose from. To gas the return a bit, an investor could buy call spreads, as long as the premium stays under the amount collected from the short put.
Does this sound confusing? I will update this trade example every other week when the contract is rolled for a better understanding. The best-case scenario is the XLF goes nowhere, and we are able to write about $1.50 in premium against the long June put.
The ratio for this example looks like this:
Sell 1 XLF Jan 11 Weekly 16.5 put @ .28
Buy 1 XLF Jun 15 put for .43