Update April 27th, 2012 at 3pm: Please see below under Trade section a second trade structure that is longer duration and almost half the premium of the Put Spread that I bought earlier.
Original Post April 27th, 2012 at 2pm: Bright Lights Big Citi
Here’s a preview of what I’ll be discussing on Options Action tonight on CNBC at 5pm eastern:
Price action in the banks continues to concern us, particularly after strong Q1 results. Investors are clearly concerned that the first quarter is an anomaly, and the revenue run rate for the rest of the year is going to be much slower, particularly for the investment banking and trading businesses. Possibly the more important story here is the continuation of the European banking crisis. If there was ever any doubt, the 2008 financial crisis was a clear demonstration of how interconnected the financial system has become globally. If the IMF is correct and the European banking sector deleverages by almost $3 trillion over the next 5 years, that will have a large impact on the capital markets businesses of the U.S. Investors don’t seem willing to wait around to find out, as European banks are still less than 10% away from 10 year lows.
is still the name we prefer to play for further financials weakness for the same reasons we laid out 2 weeks ago. From that post:
1) C was the largest recipient of govt bail-out funds during the financial crisis and the only large money center bank to fail the stress tests in mid March, and denied the ability to raise their dividend.
2) C is by far the most international U.S. money center bank, with more than half of revenues outside of U.S. Given American strength in the face of international weakness, could set up for disappointment
3) European banks could be signaling a return to potential contagion, DB for instance is down almost 15% from the March highs. Optionality in U.S. exposed banks is cheap way to play high European bank volatility.
4) High expense run rate has been a large factor in C under-performance over the last year. The problem initially surfaced in the Apr 2011 earnings report, investors will be wary of a repeat performance to start the year.
Point 4 is potentially the only one that has changed since that post, though as we mentioned at the outset, investors seem more concerned with revenues for the balance of 2012.
Finally, and obviously far less important than the points listed above, the Occupy Wall Street protests are about to hit the front of the papers again, as they have planned a May 1st countrywide protest to kick off their renewed efforts to shine light on the financial industry. The Occupy movement targeted Citi CEO Vikram Pandit this week for his comments in October that he was willing to meet with the protestors. In other words, Citi likely faces a new tide of negative headlines over the next month.
Citi’s vol and bank vol in general has hit low levels it hasn’t seen in about a year. Any hiccups this summer out of the European situation or worries about the end of Fed action in June could send vols higher and stocks lower. This is a good time to be playing in the options from the long sidefor that chance:
Skew is heavily to the downside within each month, which means a put spread structure can take advantage by selling off some downside premium against the long put in a way that is favorable:
Here’s the trade:
TRADE 1: C ($33.60) Buy July 32/27Put Spread for 1.00
-Buy 1 July 32 Put for 1.55
-Sell 1 July 27 Put at .55
Break-Even on July Expiration:
Profits btwn 31 and 27 of up to 4.00, max profit of 4.00 27 or below.
Losses of up to 1.00 btwn 31 and 32, max loss of 1.00 above 32.
OR for those looking to spend less premium and want to gain more time to see this thesis play out: Disclosure: I pitched this trade to a large institutional trader and the individual bought the fly 2,500 by 5,000. I say this just as a disclosure, this shouldn’t make anyone at home more interested in running out in doing this trade, remember most traders at large instituions have very big risk budgets and can often afford as an after thought to put trades like this in their books with very good risk rewards as a bit of an afterthought. That said here is the trade:
TRADE 2: C (33.55) Buy Sept 30/25/20 Put Fly for .56
-Buy 1 Sept 30 Put for 1.66
-Sell 2 Sept 25 Puts at .70 each for a total of 1.40
-Buy 1 Sept 20 Put for .30
Break-Even on Sept Expiration:
Profits: btwn 29.44 and 20.56 make up to 4.44 (or about 8x your money), max gain at 25.00 make full 4.44.
Losses: btwn 29.44 and 30 lose up to .56, btwn 20.56 and 20 lose up to .56, with max loss of .56 above 30 or below 20.
TRADE RATIONALE: You would only do either of the above trades if you thought that continued opposition to Euro Zone Austerity plans will cause further reverberations both politically and economically in the EU this spring and summer and that our banks most exposed to Europe will re-trace a good portion of their ytd gains. additionally you have to be of the mindset that Q1 earnings are possibly as good as it gets for most U.S. money center banks like Citi. For instance they earned .95 in Q1 and are expected to earn about 1.00 a qtr for the next 3 qtrs in 2012. In 2011, Citi earned 1.00 in Q1, 1.09 in Q2, 1.23 in Q3 and then only .38 in Q4. In 2010, Citi earned 1.40 in Q1, .90 in Q2, .70 in Q3 and then only .40 in Q4. You get my drift on the “as good as it gets” theory for Q1 if we do see any sort of slowdown?
If we see a material economic slowdown or even just a soft patch in the coming months banks like Citi’s forward guidance will get murkier by the minute, and this will likely be evident by their Q2 report in mid July. This spread isolates what I think could be a re-tracement to the unchanged levels on year that I think most banks including MS and GS could see if we have a redux of last spring/summer in 2012.