The Financial Crisis Still Weighs This Stock Down
It was ten years ago when events began spiraling out of control in the financial markets. It seemed to begin in some obscure derivatives markets. Funds invested in subprime mortgage asset backed securities suffered large losses and closed.
Soon, it spread beyond any single market and at times, in 2008 and 2009, it appeared that the global financial system was on the verge of collapse. New policies were tried, and interest rates reached record lows as central bankers fought to save the system.
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For the most part, those efforts delivered some successes. Growth returned to the global economy and although the pace of growth has been slower than desired, a complete collapse of the system was avoided, and many financial firms have recovered from the large losses.
Many, but not all firms, have seen profits and their stock price reach all time highs. Among those that have not recovered are Deutsche Bank (NYSE: DB).
Yet Another Plan for Recovery
Last week, the company announced “that it was scaling back its investments operations after another CEO change and subsequent fall in profits.
A source confirmed to Reuters that 300 US jobs were cut this week, and another 100 could soon follow. The bank has so far declined to comment on, or to even confirm the figure.
The troubled bank has recently reported a 79% drop in net profit in the first quarter and new CEO Christian Sewing said the bank will now “focus on more decisively going forward”.
As such, this move forward will inevitably involve job cuts and losses he describes as “painful but regrettably unavoidable to ensure our bank’s competitiveness in the long run.”
Some analysts noted that this latest announcement of cut backs and a retrenchment from a global focus “was a long time coming — too long, for many critics. But, they conceded there could be understandable reasons for the delay:
- Hubris: Unlike rivals, Deutsche Bank didn’t raise capital after the financial crisis, ultimately leaving it significantly weaker. By the end of last year, its tangible equity capital ratio was still below JPMorgan Chase in 2011. (Perhaps Germany’s banking regulator should have applied more pressure, as Switzerland’s did.)
- Fear: Did Deutsche Bank’s leaders worry about scaling back the investment bank because of its huge importance for revenue? (Last year, it provided 54 percent.) And about the cost of unwinding some trades?
These problems are signified by the frequent changes in the CEO. And, these problems represent challenges for the company and for investors seeking to determine if there is long term value in the company.
The next chart shows there is no reason to rush into positions from a technical perspective.
The chart shows a strong down trend in price. Momentum, shown as the stochastics indicator at the bottom of the chart is bearish.
It seems unlikely that DB will make a strong recovery from the recent sell off.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in DB
For DB, we have a number of options available. Short term options allow us to trade frequently and potentially increase our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an May 18 $14 call for about $0.35 and buy an May 18 $15.50 call for about $0.05. This trade generates a credit of $0.30, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $30. The credit received when the trade is opened, $0.30 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $120. The risk is found by subtracting the difference in the strike prices ($150 or $1.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($30).
This trade offers a potential return of about 25% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if DB is below $14 when the options expire, a likely event given the stock’s trend.
Call 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 $120 for this trade in DB.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.