I was perusing the market for cheap options in case the European financial contagion continues to worsen, and I found my trade in the most unlikely of places: Canada. My first job as a trader was as an assistant to a Canadian options trader, and I quickly learned that Canada is a small, niche market for options, but once in a while you find a good opportunity. I think this is one of those times.
First off, let me explain my general thinking. As I laid out in the Morgan Stanley piece yesterday, I think the European financial system is the epicenter for a potential contagion scenario that spreads to other financials globally, and Morgan Stanley’s recent price action reflects that worry. I will repost the 5 year chart of MS vs. European banks because I view it as crucially important:
Not surprisingly, MS has been dragged lower recently by European banks. What did surprise me, however, in my global tour today, was that Canadian banks have not joined the global bank selloff until very recently. So what do we do…
Of the Canadian banks, I chose to focus on BMO (Bank of Montreal ADR) because they have a larger international securities business with more potential counterparty risk to other global banks (like French banks, for example). Here is the 5 year chart of SX7E vs. BMO:
As you can see, BMO, like the other Canadian banks, has shown impressive relative strength. To be clear, the Canadian banks have many fundamental characteristics that are stronger than banks in other parts of the world, namely that they take less risk and are less leveraged. And I don’t think a systemic financial crisis is ever a likely event.
But it all depends on the odds that the market gives you. BMO options look very cheap to me. The September 50 strike puts are offered at $1.85, which gives me more than 3 months until expiry and only a 10% down move to break even. That’s cheap enough that I’m willing to take a bet on the low probability of an escalation of global financial contagion. In that case, investors will shoot first, and ask questions later, and BMO will move lower as well (and I think my options will be worth 5-10 times what I paid for them).
So here’s the trade:
TRADE: BMO ($53.25) Bought September 50 puts for $1.85
- Bought 1 September 50 put for 1.85
Break-even on September Expiration:
Profits with stock below 48.15. Losses of up to 1.85 between 48.15 and 50.00. Max loss of 1.85 above 50.00 on expiry.
TRADE RATIONALE:
Like I said, I don’t view this trade as a better than 50% chance of making money. But I do view it is a very cheap way of playing for the outlier event, an option trade that offers me cheap exposure to a crescendo scenario, and it gives me more than 3 months of time value to boot. It’s rare to find any bank trading at 26 implied volatility given the European stresses that are building, and that’s my main reason for playing this.