Buying Puts on Populist Scorn

By STEVEN M. SEARS | MORE ARTICLES BY AUTHOR

Sentiment on Main Street and Capitol Hill is whipsawing shares of Bank of America and Goldman Sachs. So, buy some clever puts.

 

October marks the start of the financial crisis that erupted four years ago―and it seems to suddenly be worsening, with no end in sight.

Now, as then, the financial sector's stock performance and the elevated level of options' implied volatility suggest a new, dangerous phase for the GFC, Wall Street's bland shorthand for the global financial crisis that devoured Bear Stearns and Lehman Brothers, and helped throw the world into economic chaos.

Bearish put options, now as then, are active across the entire financial sector, but the pricing of Bank of America's (ticker: BAC) and Goldman Sachs' (GS) securities suggests the two institutions are being isolated for special punishment. Self-inflicted wounds are hitting Bank of America shares. And investors are concerned about Goldman's future earnings power; some worry that the behemoth could report worse-than-expected third-quarter earnings when it reports later this month.

Bank of America's stock slipped below $6 last week. And its implied volatility has surged just above 100%, reversing course since Warren Buffett's investment―which crushed volatility and led many to believe the financial Frankenstein was suddenly safe for nonbillionaires without sweetheart investment terms.

Goldman Sachs' stock is below $100. Its implied volatility is 72%, compared with 56% for the exchange-traded fund Financial Select Sector SPDR ETF (XLF). Numbers like that normally hound mediocre banks run by journeyman bankers, not financial courtiers to countries and corporations.

We have twice recommended monetizing the pitchfork populism toward the banks, and do so again.

The American people are finally realizing that they're stuck paying big bills for rescuing big banks, just as some of those banks are gouging them with fees (BofA, for one). And still, many people cannot find jobs.

And even those with jobs are struggling to pay bills. The U.S. government is financially weakened for similar reasons, plus the cost of a long war. European governments are in worse shape for even more reasons. In short, the world is angry and depressed, and banks are wonderful targets for rage.

TO PROFIT FROM THESE DYNAMICS, use put options on Bank of America. Any stock below $6 is a perpetual option, but still consider buying one put, like a $5 strike, and selling another with a lower strike price, like a $1 strike, on Bank of America. Select puts that expire in six months to a year. This lets you benefit from high implied volatility, and a stock decline. If you are more dour, buy the $5 strike, pay the volatility premium, and see what happens.

In June, when Goldman Sachs' stock was at $136, we recommended selling a January $160 call that expires in 2012 for $3.20, now worth 12 cents, and buying the January $105 put that expires in 2012 for $2.65, now worth $17.05. At the time, anyone who did that trade was paid 55 cents. We told readers they could alter the strategy and sell the same call, but buy a January $130 put for $8.90, now at $36.34, for a quicker profit (see The Striking Price, "Pricing Those Pitchforks," Barron's, June 4).

It's now appropriate to close the January 160 call at 12 cents, since market-wide correlation is high―and the market is too volatile to ignore any risk. Sell the puts. Then, use some profits to establish a put spread at lower prices that expire in six to 12 months.

Politicians will inevitably play to the angry mob, and Goldman Sachs and Bank of America are easy targets. President Barack Obama and Sen. Dick Durbin (D., Ill.) have already criticized Bank of America for adding a $5 monthly fee for debit-card purchases. That this minor issue evoked a major reproach may suggest Washington is turning against Wall Street; harsher rhetoric will roil the Street and top banks. And just think, campaign season hasn't even begun. 

Comments: steve.sears@barrons.com; http://twitter.com/sm_sears