A Simple Way To Play Financials If Rates Rise

| October 6, 2017 | 2 Comments

C OptionsAmong the investment community, it’s easy to find commentary on popular tech and retail stocks. Given what’s been happening in Washington, there’s also plenty of discussion on healthcare companies. But one sector that’s been getting very little attention lately is financials, particularly banks.

While the banking industry has been relatively calm the last couple years, it’s still a bit abnormal to see so little news on it. For one, financials make up 15% of the S&P 500 companies, the second largest sector behind technology. What’s more, with the potential for higher interest rates in the coming months, banks stand to gain more than any other industry.

So why is there so little being written about investing in banks? It’s mainly because they’re boring. Discussing the latest exciting technology or ultra-hot retail product is far more interesting than talking about banking and interest rates.

Nevertheless, it would be a mistake to ignore the upside of banks. While banking stocks don’t often move quickly, it doesn’t mean they don’t move at all. And, with profits set to rise every time interest rates go up, it may be a good time to think about investing in high quality banks.

Here’s the thing…

At least one very big trader believes Citigroup (NYSE: C) has significant upside potential in the next year or so. The trader purchased a massive ratio call spread which doesn’t expire until January of 2019.

More specifically, the trader purchased 50,000 January 2019 C 95 Calls while selling 100,000 of the 100 calls in the same expiration period. The trade generates a credit of $0.26, which the trader collects if C closes below $95 by January 2019 expiration.

Citigroup

The call spread traded with C stock trading a little over $72 per share. What makes the trade so bullish is that max gain is all the way up to $100 per share. That’s nearly a 40% increase from current levels. Should the trade reach max gain, the spread trader will rake in $25 million in profits.

However, the trade starts losing money above $105, so the buyer believes there’s a cap on how far C could go from here. Moreover, if C never reaches $95, then the trade still generates $1.3 million in profits. Not a bad haul for being “wrong” on the trade.

Now, it’s possible the credit is what the trader is really after and there’s no expectation to reach max gain or anywhere close to it. If that’s the case, this trader is still giving a 40% cushion to the upside in order to collect this credit – something I also consider a bullish signal.

Given what we expect to happen with interest rates, being bullish on C over the next year seems like a reasonable bet. Clearly, you don’t need to do a trade as complex or risky as this one. Instead, one thing to consider is a straight up call spread.

You can buy the September 2018 80-90 call spread for $2.25 (buying the 80 calls and selling the 90 calls). Breakeven is at $82.25, so only $10 higher from here with a full year to expiration. Max gain is $7.75 (at $90 or above), so you can do quite well if the stock really takes off over the next year.

 

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Category: Options Trading Strategy, The Spread Trader

About the Author (Author Profile)

Jay Soloff is an options analyst with Investors Alley.

Comments (2)

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  1. How exactly do I do this- the latter scenario?

  2. Joe Lau says:

    Hi Jay,

    Great stuff!!!

    Just one question though. Looks to me that the only real downside to this trade is when C stock takes out the short call strike of $100 and goes beyond $105, wiping out this trader’s maximum gains while theoretically exposing him to unlimited losses. Other than that, it appears to be a win-win situation. If the call spread flops, he captures $1.3 million in premiums—a fortune for just about anyone on Main Street. If the spread works out, this trader pockets $25 million in profits. Talk about making out like bandits!!!

    Is my understanding of the rationale behind this ratio spread correct? Assuming C stock closes above the long call strike of $95 but below the short call strike of $100, will this trader be required to take delivery of 5 million Citigroup shares upon expiration? Or will the brokerage house simply go for cash settlement? In this case, is it correct to assume that C stock closing anywhere above $95 and up to $100 will generate a profit for this trader?

    It sounds to me the best of both worlds. First, it not only costs the trader nothing but also puts money in his account by selling naked calls, which in this case has a strong margin of safety. Second, given the size of this trade and assuming I am right to consider this trade profitable as long as C stock sits higher than $95 upon expiration, just the fact that the long call being exercisable will represent a windfall for this big trader.

    Options are scalable. Wouldn’t it make sense that investors with much shallower pockets copy this strategy but bet only with the money they can afford to lose?

    Best,
    Joe

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