XLF – Bank Heist

by Dan September 14, 2016 2:31 pm • Trade Ideas

By now you have probably heard and read plenty about the phantom account scandal at Wells Fargo (WFC), the company’s firing of 5,300 workers and the subsequent $185 million fine by regulators.  It’s entirely possible that these practices might be confined to just Wells Fargo. But I doubt it. I am hard pressed to think that this behavior is limited to one bank, when all of these institutions compete so fiercely for clients, deposits all based on the simple premise of cross-selling. This is purely anecdotal, but how different can the employees of WFC who service individual accounts be from those at Bank of America (BAC), Citibank (C) and Chase (JPM)? I assume the incentives for these employees industry wide are pretty consistent.

Again, this is pure speculation, but coupled with my belief that interest rates are not going meaningfully higher anytime soon (read from this am MorningWord 9/14/16: Basket of Predictables) this sort of increased scrutiny on how money-center banks are managing client accounts and squeezing account holders, I suspect we see at the very least range-bound action in U.S. banks with the strong potential for lower lows.  

To express a near term bearish in banks I want to look at the XLF, the S&P Financial Select etf, where WFC is one of the largest holdings at 8%, and WFC’s largest shareholder, Berkshire Hathaway (BRK/B) is the largest weighted stock in the XLF at 9%.  Behind those banks, BAC, C, JPM & U.S. Bancorp (USB) make up about 20% of the weight of the XLF.

Prior to the WFC news last week, and the broad market sell off since last Friday, the XLF is down 3% from its 2016 highs made last week, and down nearly 5% from its 52 week highs made last November when Fed fund futures were pricing in a high probability that interest rates would be much higher than they are today.  To my eye, $24.50- $25 appears to be stanch technical resistance, with mild support at $23, with a decent likelihood of a re-test of the uptrend down near $22.30 on a continued pullback:

[caption id="attachment_66289" align="aligncenter" width="600"]XLF 1yr chart from Bloomberg XLF 1yr chart from Bloomberg[/caption]

The etf sets up as decent short into in my mind into year end as I would be shocked if this scandal is confined to WFC, which should hurt sentiment, and be more shocked if the Fed raised rates prior to their mid Dec meeting.

So what’s the trade?  as for options trades, given the dollar strikes, its a bit hard just below $24. Given that most of the top holdings in the XLF will report Q3 earnings between mid Oct and mid Nov, Nov expiration is what you want to target if you think no rate hikes in Sept of Nov, earnings and guidance will be meh and possibly this WFC scandal weighs on sentiment for the sector.

Trade: XLF ($23.86) Buy Nov 24/ 22 put spread for 58 cents

-Buy 1 Nov 24 put for 88 cents

-Sell 1 Nov 22 put at 29 cents

Break-Even on Nov expiration:

This spread is 14 cents in the money, offers a break-even at $23.42, down less than 2% from current levels.  This trade offers profit potential of up to $1.42, or more than 2x the premium at risk, with max profit of $1.42 at 22 or lower.