Coming financial reform bill spurs options strategies

Sat Jun 5, 2010 12:34am IST

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* Put option prices in banks become expensive-analyst

* Legislation may already be priced in for big bank stocks

* Volatility over past month in financial ETFs rises

By Doris Frankel and David Gaffen

CHICAGO/NEW YORK, June 4 (Reuters) - Financial stocks may face more volatility in coming weeks as a sweeping overhaul of the U.S. financial industry looks set to pass in early July.

Options strategists say there are several strategies investors can use to play the pending financial regulation ranging from the conservative to the speculative.

"There has been concern that the pending congressional reconciliation bill would have further downward pressure on the financial sector before the fourth of July holiday weekend," said Scott Fullman, director of derivative investment strategy at broker-dealer WJB Capital Group in New York.

The sector has fallen more than the broader market in the last several weeks. The S&P Financial Index .GSPF is down about 15.8 percent since April 14, more than the S&P 500, which is down 10.7 percent in that time.

Volatility in exchange-traded funds that track the financial sector also rose over the past month.

For example, the 30-day implied volatility for the XLF rose to 34.78 percent on June 3 from 27.88 percent on May 3, according to options research firm OptionMetrics.

The legislation is being shaped into final form by a U.S. Senate-House panel, and with the final language in the bill not determined, it leaves open the possibility of surprises for investors.

To speculate or protect against a sharp decline, Fullman recommended a 1-by-2 ratio put spread in the Select Sector SPDR Financial fund (XLF.P). The ETF, which tracks the performance of the financial names from the S&P 500, ended at $14.74 on Thursday.

This involves buying one XLF July $15 put option and selling two XLF July $12 put options, resulting in a total net cost of 59 cents. The upper break-even point is $14.41, the lower break-even is $9.59. Below $9.59, the strategy loses money, he said.

An equity call option allows share purchases at a fixed price up to a certain date. A put option grants the right to sell the shares at a preset price anytime until expiration.

Brian Overby, senior options analyst at online brokerage TradeKing in Charlotte, N.C., said put option prices in the banks have already become "quite pricey."

"One way to lower the cost of protection is to employ a collar strategy, a trade that can give some downside protection while waiting for the outcome of financial reform legislation," Overby said.

With a so-called collar, an investor who owns 100 shares of Goldman Sachs Group Inc (GS.N) can purchase a July $135 put at a $5.25 premium. At the same time, the $150 GS July call option is sold for $5.40. That premium received for sale of the call would help fund the put purchase.

Goldman traded at $145.43 on Friday.

This trade limits the downside risk if Goldman shares drop below $135. But gains are capped, since shares can only rise up to $150 before the investor is obligated to sell the stock by July expiration, Overby said.

PRICED INTO THE MARKET?

Victor Schiller, president of InvestorsObserver.com, an equity options research and analysis firm in Charlottesville, Virginia, said current bank stock prices already reflect expectations for lower profits from the anticipated bill.

"The worst case scenario of this bill is probably baked into the most widely-held bank issues such as Goldman Sachs, Citigroup Inc (C.N), Bank of America Corp (BAC.N), and Wells Fargo & Co (WFC.N)," Schiller said.

He suggested a June $35/$30 bull-put credit spread in JPMorgan Chase & Co (JPM.N), where investors would buy one June $30 put for every June $35 put they sell on the view the stock does not have much further to fall by June 18 expiration.

"The stock would need to drop below $35 by June expiration for this position to start losing money," he said.

But there are wild cards in the legislation. Key reforms still under consideration would require reporting of over-the-counter derivatives trades to regulators. The Senate measure goes a major step further in requiring banks to spin off their swap-trading units. [nN0397139].

(Reporting by Doris Frankel; Editing by Andrew Hay)

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