Sunday, December 20, 2009

The financial short strangle


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The cold reception received from citigroup's equity offering as part of the effort to pay off the TARP money was indeed disappointing.  However, the outlook seems to be brightening in the longer term.

Look at it this way, the act of paying back Fed's money in itself is a show of financial strength.  We know they still have toxic assets on their book (the estimate is around 50% left) and they have to raise the money from diluting equities.  As a sign of how far we have come, I still remember having the feeling that every major banks seemed to be at the risk of failing and that the world is coming to an end back in March this year.

I am not just speaking about C but the same for the rest of the major US financial institutions like GS, BAC, JPM and WFC.  But in the short-term (3 - 6 months), I feel that share prices of these financial institutions are going to be range-bound as they're transiting from a liquidity-flushed rally (the easy money) to a normalization of profit (sustained earnings).  Investors and speculators want to see REAL earning, not those Fed-inspired dollars, before placing further money on the table.  The earliest estimation for the normalization is expected only in 2012.  Currently, BAC, JPM and WFC are trading at less than 9X the projected 2011 earnings.   Citi trades for a fraction of its estimated tangible book value of $4 and at 6.6 times potential normalized profits of 50 cents a share in 2012.

A short strangle on these financial institutions seems to be right strategy to employ in this range-bound market.  It involves selling a Out-of-the-Money (OTM) call and put simultaneously.  For this strategy to be successful, the market has to be range-bound and delta neutral.  Selling a OTM call(170) and put(155) is one such combinations for GS:

This is the GS daily chart:

As mentioned earlier, it appears to be range-bound or flat at best --  the recent short-term bearishness seemed to have bottomed (see the divergence) but the upward momentum looks weak.  The next thing to look for is the upper and lower limits or break-even.  You need to experiment the different combinations of strike prices to find the maximum premium you can receive.

Once you've entered the trade, you'll be finding ways and means to make sure you that you get to keep the double premium and not give it back.

For the 155/170 short strangle, the premium received is $546 (max profit) per contract while the loss theoretically unlimited.  The two strikes, 155 and 170 will form the upper and lower limits.  For maximum profit or $546 per contract, GS has to expire between $155 and $170.

In terms of risk management, I have sufficient underlying stocks to covered the upper limit risk so my attention will be focused on the lower limit risk.  In the event of an assignment (worst scenario), I am happy to take shipment of NEW shares of GS at $155 per share excluding $5.46 per share in premium, effectively lowering my buy price to $149.54 per share. 

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