The Financial Sector Select SPDR ETF (XLF) hit its high of 35.68 on Nov. 1, 2006. A little more than two years later it hit its nadir of 6.17 on Feb. 1, 2009. XLF consists of 10 firms that are either investment banks or old fashioned banks. Berkshire Hathaway (BRK.A) and JP Morgan JPM) each comprise more than 10% of the fund with Wells Fargo (WFC), Bank of America (BAC) and Citigroup (C) rounding out the top five.
Citigroup comprises 5.56% of XLF, has a market cap of $166 billion and a price/earnings (PE) ratio of 12.67. Wells Fargo has a PE ratio of 14.51, while BAC’s is 16.45; both higher than Citi but not by a lot. On Sept. 30, 2006, Citi traded at $55.70, but on Jan. 1, 2009, Citi traded as low as $2.53. After the 2008-2009 liquidity crisis Citi continued to trade in low single digits and went ahead with a reverse split of 10-1 that began trading on May 9, 2011. Today’s price of $59.81 would be $5.98 before the reverse split.
On Feb. 1, 2016, Citi traded at $34.89. By Feb. 27, 2017, it nearly doubled to $60.02. Citi is due for a breather, if not a reversal. How to trade it? You can buy puts outright or buy an April 60 at-the-money put for $2.15. The breakeven point is $57.85. If you buy 10, you lose $2,150 should Citi close at $60 or higher at expiration (55 days away). The puts’ time value rate of decay picks up speed every day. You can counteract that decay by selling a put against your long put. By selling the April 57.50 puts at $1.09 against your long 60 puts, the shorts would be decaying in tandem with the longs. Your maximum loss would be reduced to $1,060. Your maximum profit would be reduced to $1,440. You can go further out on the expiration calendar while at the same time buying something further out-of-the-money, like the June 52.50 puts for 0.85. The breakeven point is $51.65, $6.20 lower than the April 60 puts but with an additional 56 days for something to happen.
The bearish strategy that we are going to settle on is the time value spread. These spreads are also referred to as calendar, horizontal or simply time spreads. Long time value spreads occur when you go long an option in a deferred expiration cycle while simultaneously going short the same strike in a nearby expiration.
Let’s take a look at the April-March 60 put spread with Citi trading at $59.81. The April 60 puts are trading at $2.14, the March 60 puts at $1.20. The value at expiration in both cases would be 0.19 with Citi at $59.81. The difference in the respective premiums consists entirely of time value. The greatest value for the long time value spread is when the underlying goes out at the strike price. At the March expiration if Citi closes at $60, the short March 60 puts go out worthless. At $62, the March 60 puts still go out worthless but the value of the long April 60 puts would be diminished. At $58, the short puts gain value along with the long puts. If Citi collapses then the time value in your long puts diminishes and the spread narrows. To the upside, eventually both puts become worthless and the spread also narrows. When you go long an at-the-money time value spread you want very little volatility. You are happy to see the front month time value disappear so that the spread widens.
Time value spreads are most valuable at the strike. If you’re expecting a 12% decline in price, then establishing a long time value spread at the 52.50 strike makes sense. That happens when you buy the June 52.50 puts for 85¢ and sell the May 52.50 puts for 58¢, creating a 27¢ debit. The most that you could lose if you do it 25 times is $675. Even if it made a gap move down there today you could pocket close to $400. If it moved there a month from now you would make even more.