New Trade MS: Shorting another House of Morgan

Here is a preview of what I will be discussing tonight on Options Action on CNBC at 5pm:

“Strong” earnings reports from JPM and WFC this morning have given the entire banking sector a strong bid today. First of all, I read through the JPM report and listened to the conference call, and I think Jamie Dimon did a great job of schmoozing the crowd, but did nothing to change my mind about the future prospects of JPM over the next 6 months. The price action today is no doubt painful, but I have confidence that my August puts and my short August call spread will both make money by expiry.

In the meantime, I want to use this rally in the banks as a good trading opportunity. Specifically, JPM’s earnings report highlighted the broad-based weakness in all of the investment banking businesses (the retail banking side was strong, same for WFC, and the rally in WFC has more legitimacy to me as a result). Dimon was also not too optimistic on Q3 capital markets businesses, mentioning that they’re tracking Q2 so far, Europe and Asia specifically weak. So I want to buy a put spread on a pure investment banking name, which really only leaves MS and GS left to report next week.

I’m focusing on MS for the following reasons:

1) MS has a very high correlation to European banks over the last 5 years. European banks have been acting quite poorly post-European summit. Deustche Bank made 6 month lows today. Moreover, Italian and Spanish yields have been inching higher, both above 6% to close the week, which is not a positive sign for systemic stress. Here’s the chart showing MS vs. SX7E (the European banking index) over the last 5 years (I actually mentioned this chart in my MS Oct 10/5 1×2 put spread idea from May 30th here):

2) MS estimates for next year are 40% higher in 2013 than in 2012, so they will likely have to come down substantially if the trends that JPM reported continue. Estimates for GS are only 20% higher, though even those are probably too high.

3) Historically, MS has just been a poor executor. So if JPM is having trouble in investment banking, then my guess is MS is having an even worse go of it this year. I am looking for that historical underperformance to continue.

Here’s the trade:

TRADE: MS ($14.05) Bought August 13/11 put spread for 0.30

Bought 1 August 13 put at 0.40

Sold 1 August 11 put at 0.10

Break-even on August Expiration:

Profits with stock btwn 12.70 and 11, with max gain of 1.70 if stock is below 11

Losses of up to 0.30 btwn 12.70 and 13, max loss of 0.30 at 13 or above

TRADE RATIONALE:

MS reports earnings on July 19th. Based on JPM, I don’t expect a strong report. But more importantly, I expect continued pressure on investment banks in general because of the weakness emanating from the European banking system. That’s why I chose to use August as opposed to the July options. Also, the skew, or vol difference, between the Aug 13 and Aug 11 strike is too high in my view, about 13 vol points, and this trade takes advantage of that.