Trade in Groups

Binary options (see: “Understanding Fixed Return Options (FROs)” offer traders another way to make leveraged bets on equities. While the total number of stocks and indices on which FROs are available is still relatively small due to FROs only being available for a handful of months, I see several trade set-ups:

After hitting an intra-week low of $7.80 last week, Wachovia (ticker: WB) rebounded on the strength of earnings from banks such as Wells Fargo (WFC) and US Bancorp (USB) to close at $12.97. While expectations are certainly extremely low for pretty much all lending institutions, there are significant differences in quality between banks like Wells Fargo and Wachovia. Wachovia’s loan portfolio is of inferior quality, and their Tier One capital ratio is relatively low and continuing to fall despite hugely dilutive capital raises. Until there is a clear sign of the ultimate magnitude of charge-offs and capital needed, you need to be skeptical of rallies in most financials. The October $20 mark on both the Finish High and Finish Low FROs have the greatest open interest; if liquidity allows, I would look to be short the Finish Highs and/or long the Finish Lows.

Likewise, Citigroup (C ) jumped almost 8% Friday after its earnings, despite seeing its North American credit loss ratio up 170%. Citi’s saving grace looks to be its strong increase in net interest margin – or the spread between what it pays depositors and what it makes on loans; cynics might note that this number was once the driving force of bank earnings before we entered the era of highly leveraged structured products transactions. Still, this is a company that had to issue almost $13 billion in common and preferred stock to build its Tier One capital ratio, which is going to hamper future earnings power (per share) due to the dilutive effect. This could make Citigroup a long-term flatliner because EPS growth might not be enough to offset the larger number of shares outstanding, making any options bets I make here tilted toward the bearish side.

Since these two trades would put you net short financials, how to hedge that exposure? One could bet long via Finish High FROs on the S&P Financial Sector (XLF), essentially creating a relative value proposition whereby one expects the index’s higher exposure to the financials I like more (i.e. American Express, 2.75%; Goldman Sachs, 3.58%; JP Morgan, 7.5%; US Bancorp, 2.95%; Wells Fargo, 4.67%) offsets a combined 8.5% exposure to the Wachovia/Citi combo detailed above. Another possible hedge would be to go long the Finish Highs on the S&P 500 (SPY) on the thesis that a recover in the financials – which might put the two short FRO ideas above underwater – would be offset by a broader market recovery.

Read the free Whitepaper on FROs.