We’ve said there are a couple of catalysts that could help push this market toward a correction, and one is a sector that’s responsible for several big market moves.
The big banks could definitely steer that, so we want to watch that one really closely. Now, unfortunately, the traders have really been favoring the big bank stocks for hedges against a potential decline because they figure – not unjustifiably – that if the market does head down, especially if the catalyst was Europe, then the big banks, which have massive exposure to European funds, like JPMorgan Chase (NYSE:JPM) [which reported earnings and moved about 2.5% intraday], Goldman Sachs (NYSE:GS), Citigroup (NYSE:C), etc., could lead that decline.
So, for the last week and a half or so, they’ve really been doing a lot of hedging with puts on those big banks, and it’s driven the price up beyond levels that we’re really comfortable with.
One of the things that we integrated for our analysis is that options prices aren’t linear with the underlying stock itself. They have a high level of correlation but sometimes they will rise really fast and investor expectations for a big move are rising, even if the underlying stock isn’t moving very fast at all.
There are even occasions where the stock may drop a little bit and, yet, puts will fall in value. Or, the stock may rise a little bit and the puts will rise in value, just because there are some X factors in the way that options are priced that present some unknowns. When the premium is a little inflated or a little deflated, it can present opportunities, as well as special risks.
One of the things that we avoid are options that when we look at where the stock is right now from a technical, as well as a fundamental perspective, when we examine the options price, we ask, “Are the options on average cheaper than they have been in similar situations in the past?”
If they’re more expensive, we tend to shy away, and that’s been the case with a lot of the bank stocks, so there’s nothing there that is really attractive because you could be a little right and still be wrong on the trade. That’s the give and take you have when you buy options with an inflated premium.
Investor Place advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.