New Trade XLF: The “Hard Trade” Here is Pressing the Short

by Dan May 11, 2012 10:50 am • Commentary

JPM news last night implies much stricter controls on risk-taking for the other U.S. banks going forward.  If you believed bank managements before that the bulk of their trading profits come from CLIENT positions, this should be enough to change your mind. Trading profits going forward will be significantly reduced for all the investment banking related names, Q2 earnings could reflect this foregone conclusion, but the outlook given on most of the conference calls in mid July will surely reflect this sentiment.  

As we readers know we have a few outstanding trades that are short U.S. banks, but we want to throw out a low premium, low risk high reward trade that would benefit from a sort of perfect storm situation playing out by July expiration.   While many individual bank stocks are getting a bit near term oversold, we want to take a look at the XLF.  The XLF is a tricky etf as it’s make up is slightly divergent btwn U.S. centric “fortress”  type names like WFC and BRK/B that make up almost 18% of the weighting in the top 3 of it’s holdings and then gets into the lower quality Europe exposed names like Citi, BAC and JPM.  See weighting below.

[caption id="attachment_11712" align="aligncenter" width="605" caption="XLF weighting from Bloomberg"][/caption]


TRADE: XLF ($14.87 )  Bought July 14/12/10 Put Butterfly for .20

-Bought 1 July 14 Put for .33

-Sold 2 July 12 Put at .08 each for a total of .16

-Bought 1 July 10 Put for .03

Break-Even on July Expiration:

Profits btwn 13.80 and 10.20 make up to 1.80 or 9x your money, max gain of 1.80 at 12.00, pay-out trails off btwn 12 and 10.20

Losses of up to .20 btwn 10.20 and 10 and btwn 13.80 and 14, max loss of .20 above 14 or below 10


TRADE RATIONALE:  I don’t exactly want to press individual names here on the short side, we have been early on this trade and it is working and we have already take profits an half of MS and Citi Put Spreads, so we can’t lose on them.  But now we want to play for the lights out redux of last summer as increased focus on banking regulation and a flare up of Europe’s sovereign debt crisis take down the other so called “best of breed” in the banking sector.

Not trying to confuse any of u, but a logical question would be why do the fly and not just the July 14/12 1×2 put spread, well for professionals we wouldn’t suggest to buy the July 10 put, but for those of us who have margin issues and risk management issues this can make sense just to buy that way downside wing to cover your arse.

One last point the bid ask is fairly wide, so if you trade these structures always use limits, when I Bought this fly the bid was .13 and the ask was .22, I first tried .19 bid and then .20 and got filled.