Long/short options ideas on European banks in June 2024

The investment strategies proposed in this article are suitable for professional investors only.

In the year ending 3 June 2024, European shares in the financials sector, and the banking industry specifically, have managed to see their prices rise even more than stocks focused on “hotter” themes such as artificial intelligence and weight loss drugs. With the Swiss National Bank having already started rate cuts, and many eyes on the European Central Bank and US Federal Reserve to see if they’ll do the same, it is an interesting time to consider exposure to European banks. Options represent an attractive way to gain such exposures, with Cboe Europe Derivatives (CEDX) currently offering options on 14 bank stocks from across Europe.

In this article, we consider two option strategies for traders looking to put on a long/short position on two European banks, where the options provide hard limits on the upside and downside risk, and also provide an additional spread trade on the relative volatility and volatility skew of the two bank stocks. These strategies will be illustrated using two fictitious bank stocks: Alpine Bank, on which the trader is bullish and wants long delta exposure, versus Rhine Finance, on which the trader is bearish and so wants short delta exposure. The two different option strategies will then differ on their ranges of possible outcomes, and on their relative exposures to volatility and skew.

Advantages of putting on this long/short trade through options strategies like these, rather than by directly buying Alpine and selling short Rhine, include:

1.   Maximum loss on the short Rhine position can be strictly limited

2.   Financing and borrow costs on the long short position are locked in for the term of the trade, and

3.   No exposure to having borrowed shares called back by the securities lender

For simplicity, we will assume both stocks are currently trading at exactly 100 per share, and no dividends are expected to be paid between now and option expiry.

Strategy #1: 30 Delta Put vs Put

The first strategy we will consider here is one where the trader sells the 30 delta put on Alpine Bank, versus buying the 30 delta put on Rhine Finance. For a stock currently trading at 100, these 30 delta puts could be ones with three months to expiry and a strike price of 95, assuming an implied volatility (IV) of 27%, which is in the range of current 30 delta option volatilities for many European banks. It is possible this spread may be available “costless” if these two options happen to be trading at the same implied volatility, or at a net credit if Rhine Finance trades at an IV higher than that of Alpine, versus a net cost if Rhine’s IV trades below Alpine’s. If held to expiry, four sample combinations of how the net values of these options would add up at expiry could be:

1.   If both stocks finish above the 95 strike price, both options expire worthless, and trade nets nothing other than any net credit or debit from when the trade was initiated, or

2.   If both stocks decline by the same amount, say by both falling to 90 by option expiry, then the gain on the long Rhine put offsets the loss on the short Alpine put, so the trade nets nothing other than any initial credit or debit, or

3.   If Rhine falls more than Alpine, say with Rhine falling to 85 while Alpine has only fallen to 90, then these options will net a payoff of +5 points to the trade, or

4.   If Alpine falls more than Rhine, say with Rhine only falling to 90 while Alpine has only fallen to 85, then the trader will need to make a net payout of 5 points at expiry.

The selection of the 30 delta strike price means that this trade will net next to nothing in scenarios where both stocks trade up or sideways, and so this trade is primarily meant to capture a significant move down, with the view that in such a scenario that Rhine would fall significantly more than Alpine. The relative outperformance of Alpine over Rhine in scenarios less bearish than these could be captured by doing a similar trade using options with higher strike prices, even in-the-money puts with deltas higher than 50.

A secondary factor in this type of trade is to capture the spread between the implied volatilities of the two stocks, which in turn applies a contrarian view: if Alpine options trade at a higher IV than Rhine options, that implies the market considers Alpine a riskier bank than Rhine, so selling Alpine puts and buying Rhine puts is one way to capture the premium the market offers for taking Alpine risk over Rhine risk.

Strategy #2: Long Call Spread vs Short Call Spread

Another limited risk way of putting on a long Alpine / short Rhine position is by buying a call spread on Alpine and selling a call spread on Rhine. As with the put vs put trade above, this trade also aims to capture the relative outperformance of Alpine over Rhine while limiting the risk if Rhine rises significantly, while adding protection against Alpine falling significantly. For this example, we will assume that we are buying the 90-110 call spread on Alpine and selling the 90-110 call spread on Rhine, both with six months to expiry. As both of these trade in Euros, and neither stock is expected to pay a dividend over the next six months, then this spread nets out as a “skew trade”, meaning the net cost of this trade depends more on the relative IVs of between the 90 and 110 strike calls of each stock, rather than the relative IVs between the two stocks.  After settling the net cost or credit of putting on this trade, then the net payoff of this pair of call spreads at expiry would be:

1.   If both stocks finish above 110, the spreads cancel each other out and the net position is worthless, or

2.   If both stocks finish below 90, both spreads expire worthless and the net position is worthless, or

3.   If Alpine finishes above 110 and Rhine finishes below 90, the trader receives a net payout of 20 points, or

4.   If Alpine finishes below 90 and Rhine above 90, the trader pays out the worst-case loss of 20 points, or

5.   If Alpine finishes at 105 and Rhine finishes at 95, then the 15 point payout from the Alpine call spread minus the 5 points paid out on the Rhine call spread results in a net payout to the trade of 10 points, or

6.   If Alpine finishes at 95 and Rhine finishes at 105, then the 5 point payout from the Alpine call spread minus the 15 points paid out on the Rhine call spread results in a net loss of 10 points the trader needs to pay out

As these examples should make very clear, this long/short pair of call spreads provides exposure to outperformance of Alpine over Rhine only within this pre-defined range, so choosing this range is quite important. A secondary factor in this trade is the implied volatility skew priced into these call spreads, which can be seen in the prices of the spreads when the trades are put on, but can also affect the result if this trade is unwound prior to expiry. For example, if this trade is put on with both the Alpine 90 and Rhine 90 calls at 27% vol and both 110 strike calls at 24% vol, and then the next day nothing else changes except that the IV on both Rhine options somehow manage to flatten to 25 vol, than this trade would move against the trader by one point solely due to this change in volatility skew.

Conclusions

The risk of long/short equity trades can be tightly targeted and limited by using options strategies rather than outright long and short equity positions. 

Learn more:

Visit Cboe’s Options Institute to explore the basics of options trading here.

Cboe Europe offers trading in shares from across Europe and, through Cboe Europe Derivatives (CEDX), options are also available on shares in over 300 leading European companies.

 Learn more about CEDX here.

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·      The above is the product of external market analysis commissioned on behalf of Cboe Europe B.V. The views expressed herein are those of the author and do not necessarily reflect the views of Cboe Europe B.V., Cboe Global Markets, Inc. or any of its affiliates (‘Cboe’). For more information on how this research was conducted and/or the author please contact [email protected]

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