Deutsche Bank Shows a Clear Trend
Deutsche Bank (NYSE) DB) sold off on Friday after the company reported its third consecutive annual loss. The loss for the year was just one piece of news that caught traders’ attention. The company also warned investors that the current year will not be as profitable as expected.
Speaking about the current year, James von Moltke, chief financial officer, told analysts that the bank would step up efforts to increase profitability. “We are not cutting costs fast enough,” he said. “Deutsche Bank’s cost culture has to improve.”
The CFO blamed slower than expected asset sales. He said the company failed to sell parts of the company’s business that would have reduced costs by $1.1 billion.
Despite failing to meet cost cutting goals, the bank did increase the size of the bonus pool. Bank CEO John Cryan said the higher bonuses were a “one-off investment” necessary “to secure our franchise and to strengthen our position in key sectors”.
He added, “In the coming years, these kind of bonus payments will only be justified if the bank performs correspondingly.” However, he did not provide any specific information about how bonuses will be justified.
This loss continues a negative trend in the company’s overall financial performance that can be seen in the chart below.
Source: Standard & Poor’s
As the chart shows, Deutsche Bank has reported a loss in each of the ten past quarters. Losses have been steeper during this trend than they were in the 2008 global financial crisis. The trend in revenue is also lower after that measure peaked in 2015.
Quarterly Performance Also Missed Targets
For the fourth quarter, the banks reported revenue of $7.1 billion, significantly less than the consensus analyst forecast of $7.7 billion. The net loss of $617 million was also worse than expected. On average analysts had been expecting a loss of $365 million.
For these problems, the CFO blamed the markets.
“Markets were half moribund at the end of last year,” Mr Cryan told analysts. In a statement, the bank pointed to “low volatility, low institutional client activity and difficult trading conditions in certain areas”.
Moody’s analyst Peter Nerby noted that while low capital markets activity caused the drop in revenue, “it may also be contributing to some rethinking of strategy by management — as they attempt to gauge which downturns in activity are structural as opposed to merely cyclical”.
There was some good news. The bank’s core tier one capital ratio increased to 14% at the end of the year, up from 13.8% at the end of the previous quarter.
Tier 1 capital ratio is the comparison between a banking firm’s core equity capital and its total risk-weighted assets. It is a measure of a bank’s financial strength. Under international regulations, this measure of capital must be equal to at least 6%.
Although DB is able to meet regulatory requirements, investors have not been buying the stock for some time.
The stock is more than 80% below its peak and unlikely to rally in the short term after the disappointing earnings report for the year.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in DB seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This best option strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for Deutsche Bank
The bearish outlook for Deutsche Bank, at least for the purposes of this trade, is a short term investment opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the February 16 $18 put can be bought for about $0.65 and the February 16 $17 put can be sold for about $0.20. This trade will cost about $0.45 to enter, or $45 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $45. This loss would be experienced if DB is above $18 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in DB, the maximum gain is $0.55 ($18 – $17 = $1.00; $1.00 – $0.45 = $0.55). This represents $55 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $45 to open this trade.
That is a potential gain of about 22% of the amount risked in the trade. This trade delivers the maximum gain if DB closes below $17 on February 16 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $45 for this trade in DB.