Deposit Bank Options in Your Portfolio

The accelerated expectations for the Federal Reserve to raise its overnight lending rate have installed a cloud over companies that are interest-rate sensitive, like financial services firms. Large banks have been hit particularly hard, with the Philadelphia Bank Index(BKX Quote) down 23% and the S&P Financial Trust (XLF Quote) falling 12%, over the last four weeks.

Darkening the picture was Citigroup's(C Quote) recent decision to fork over about $2.65 billion to settle class-action suits related to the involvement of its investment banking and research departments (and never shall the twain meet again) in the Enron and Worldcom fiasco. This move had investors thinking that other banks, namely J.P. Morgan(JPM Quote), will need to boost its set-aside money to pay for the roguish roles they played in that web of investor deceit.

Certainly rising rates and litigation are potential negatives for these companies, but I think the near-term reaction is overdone and that fears about the ultimate impact are overblown. I view this as an opportunity to start building a bullish position in these franchise names that dominate the industry.

Not So Certain? Use Dispersion

One way to get into some long positions with minimal risk would be to use a simplified version of the dispersion trading strategy. This involves buying options on an index- or exchange-traded fund while selling the options of the individual issues that comprise the index. The theory is that component issues will have higher implied volatility than the implied volatility on the overall index.

This article of mine on dispersion trading from last July, provides not only more details of the concept but also includes an example applied to the Semiconductor HOLDRs Trust(SMH Quote).

What I suggested was selling short SMH puts while buying puts on three of its individual components: KLA-Tencor(KLAC Quote), Teradyne(TER Quote) and Novellus(NVLS Quote). My premise at the time was that the sector had recently racked up major gains, with the SMH having moved up 32% to $31 in the prior three months, and that the above-mentioned individual issues might be particularly susceptible to a major stock decline. The theory was that the weight of those three stocks accounted for only about 6% of SMH's price -- a tumble in them would not necessarily bring down the SMH by an equal price percentage basis.