Stress-Free Investing In Stress-Tested Banks

Finally the official results are in!

Oddly enough, it was MUCH worse than the original indication that started this leg of our rally when we were told that every bank passed the stress test but the results were skillfully leaked in dribs and drabs interspersed with rumors that things were much worse in such a way that there is a general sense of relief that "only" $75BBn of additional capital must be raised and almost half of that by Bank of America, where $34Bn represents just 2% of their assets (although it is 40% of their current market cap). 

While that level of dillution will keep us out of BAC for now, there's no reason to not invest in C, who "only" need $5.5Bn against their $2Tn in assets although that is still 25% of their current market cap.  For the banks that do need capital, they have until June 8th to present a plan for raising it and until November 9th to implement the plan, which must maintain the target capital ratios through December 2010 after which we can assume they will again be allowed to run wild.  The banks are all coming up with various schemes to raise cash but the ones on the left need none at all.

Rather than go into a huge explanation about each pick, I'll just say that I'm favoring banks that I feel have room to run and have not already been overbought.   I discussed with members yesterday that it is ridiculous to assume that banks will get back to their 2007 levels as those earnings came under unique and ideal market conditions which are not likely to be repeated in the next decade so I was disgusted with Cramers BUYBUYBUY rant on the banks last night and I'm looking for a far more conservative play and we will be shorting some of the high flyers as Cramer herds his sheeple into overvalued positions.

We got out of our bullish bank plays this week and our $100K Hedged Virtual Portfolio, which was focused on financials in round 1, made huge gains and we (contrary to Cramer's advice) took them off the table.  Now that we have FACTS, we can reinvest with more confidence.  I am not advocating jumping into all of these positions ahead of the weekend, we still want to see stability next week but we can scale in by selling puts on those banks that sell off as the first leg of an entry point and selling calls of the stocks we feel are irrationally exuberant as the first leg of our plays.  By taking advantage of what we consider "wrong" moves with small, initial entries, we can have a little speculative fun while working into our hedges.

Before we talk about making bullish investments in banks, let's talk about a bullish hedge against them.  Most of our buy/write plays are designed to give us a 15-20% discount on the stocks we select (see "How to Buy Stocks for a 15-20% Discount").  Since we are already hedged for a 15% drop in the financials, the overriding hedge we require is for something WORSE than that.  So if we have $10,000 in long financial positions, we should be hedging for perhaps $2,000, which would cover the loss, not from $10,000 to $8,000, which is already covered by the individual hedges on the stocks we buy, but for the drop between $8,000 and $6,000.  That means that we can get by with less coverage. 

Ideally, our goal of covering and scaling in is that, if the stock dips 20%, then we leave our hedge in place and buy the next round as planned.  If the stock dips 30-40%, we cash in our hedge and either kill the play (as it's gone "wrong") or, if we still like the bank and think the panic is unfounded, use the money we made on the hedge to dollar cost average into the position at a far lower price.  In other words, if I like C at $4.30 and we take a hedged entry at $3.50 but they announce a huge dillution and drop to $2.50 but we still like them, if our hedge makes $1 (covering the $1 loss beyond our primary hedge) we use that profit to buy 40% more shares at $2.50.  That lowers our basis from $3.50 to $3.10, back on track with "just" a 20% loss on our first set of shares but with 40% more shares than we would have had otherwise.

Keeping that in mind, our master hedge is:

FAZ Oct $2 calls at $3.25, covered with July $5 calls at $1.75.  That puts us in FAZ at, effectively $3.50 (the strike plus our net payment of $1.50) with an obligation, if FAZ goes higher, to sell it at $5 if it's over that price on July 17th (options expiration day).  That would be a $1.50 profit (43%) if the ultra-short financial index stays flat to where it is now or goes any higher.  There are other issues like rolling etc. that make this an even better play but we'll keep it simple for our purposes.  So, if we want $1,500 worth of downside protection against our long positions, we simply buy 10 contracts of each for $3,500.  While the $3,500 is "at risk," we are protecting against 2 months of sales and we expect to sell more calls in Aug and Sept so we will have many upside profits against this potential loss.  A drop below $5 will wipe out the calls we sold (so we owe them nothing) and, since the July $9s ($4 out of the money) are $1, we can assume we will retain some value even if FAZ drops in half.

Now we are armed with $1,500 in protection and we can select some banks to play with hedges:

500 shares of C at $4, selling June $5 calls for .30 and selling June $4 puts for $1 net entry of $2.70 with the possibility (if C hits June 19th below $4) of having 500 more shares put to us at $4 per share for an average entry of $3.35, a 16% discount off the current price.  Please note that all prices are best guesses based on pre-market opens and, again, we are intending to scale into plays slowly between now and next week and will be taking advantage of banks that give us BETTER entries than those planned.  So the net allocation is $1,350 and whatever margin is required for 500 more shares at $4.  We calculate our "need" for a hedge as 20% below our average put entry of 1,000 shares at $3.35 so 20% of $3,350 is $670 of our hedge used on this position.  Our profit expectations are to be called away at $5 on 500 shares with a net profit of $2.30 or $1,150 (85% on the cash laid out by July 17th).  Also note we make our C money in June and we can do it again the next month!

The nice thing about these plays is C can DROP to $4 and FAZ can stay at $5 and we win on both ends of the trade, making $1.20 per share on C (anything above $3.40 is some kind of win) AND making our $1,500 on FAZ.

MET is not a bank but they don't need money and, unlike banks, they don't need derivatives to make it.  The stock is at $32 and we can sell 2 June $28 puts naked for $1.90.  That would give us a net entry of $26.20, an 18% discount off the current price and, since we are obligated to buy it at $28, a drop of 40% in MET would take the stock to $19.20 and cost us net $10.90 per share, which is unacceptable so we set a stop loss plan on this one.  Our trade plan for MET would be to sell 2 more shares at $3 (assuming we still had faith at the time, otherwise kill the trade with a $220 loss) for an average sale price of $2.45 on 4 contracts sold, at which point we would set a stop at $3.50 (as that would mean things are going very wrong) and we would take a total loss of $420 on the play so that is our net coverage requirement.  We are committing no capital but will be required to set aside margin for 400 shares times net $25.55 (at most if second round required) for $10,220.  Our max profit is, of course, keeping the $380 or $980 we collect from selling the puts.

• 200 shares of STI at $18.50, selling June $17 calls for $3.50 and June $15 puts for $1.50 nets $13.50/14.25.  Commitment is $2,700/5,700 so protection required is 20% of $5,700 or $1.140 and profit expectation on getting called away on 200 shares at $17 on June 20th is $700.
• 500 shares of FITB at $6.50, selling June $6 calls for $1.20 and June $6 puts for .85 nets $4.45/5.26.  Commitment is $2,225/5,260 so protection requirement is $1,052 and profit expectation on getting called away on 500 shares at $6 on June 17th is $775.
• 300 shares of KEY at $7.40, selling June $6 calls for $2.25 and June $6 puts for .50 nets $4.65/5.32.  Commitment is $1,395/3,192 so protection requirement is $638 and profit expectation on getting called away on 300 shares at $6 on June 17th is $405.
• 100 shares of USB at $20.70, selling June $19 calls for $3.50 and June $17.50 puts for $1 nets $16.20/16.85.  Commitment is $1,620/3,370 so protection requirement is $674 and profit expectation on getting called away on 100 shares at $19 on June 17th is $280.
• Selling 2 naked June $37 puts on STT for $3.  Commitment is margin requirement on the possible assignment of $8,100.  As with MET, we can plan to double down at $5 with a stop at $6 for a total risk of $800 with a profit of $600 if the original 2 puts expire worthless or $1,600 if our pressed bet expires worthless.  As with any naked put sale, you should not initiate the trade unless you are willing to own 400 shares of STT at net $33 (18.5% off the current price of $40.50).  Of course we would be happiest to see STT trade down and give us our first 2 sales closer to $5 (was $4 yesterday) so patience is key with these plays and no big deal if they get away from us.

Those are the ones I like best at the moment.  The others seem a little overbought and either they come down a bit and we get interested or the next article will be on shorting the banks that have gotten ahead of themselves!