Bank-Induced Uncertainty Is Bringing Traders Opportunities

It’s a déjà vu moment…

Volatility is on the rise. Banks all over the globe are scouring their books to check their exposure. And market pundits are racing to connect the dots to come up with their “Next Lehman” moment.

It’s enough to scare many folks right out of the markets.

Only a week after the nearly four-decade-old Silicon Valley Bank (SVB) went out of business in two days flat – Credit Suisse is teetering on the brink.

It’s been saved, for the time being, by a 50 billion Swiss franc ($50 billion USD) injection from the Swiss National Bank. But when you see governments stepping in to bail out banks, you know something is not right.

While the biggest banks like Bank of America and J.P. Morgan are looking secure, there could be other failures like SVB and Signature Bank.

So, we need to pay even closer attention to the markets now. Our job as traders is to read the play and act accordingly… and to always be on the lookout for opportunity.

Mispricings and Distortions

Market uncertainty leads to mispricing and distorted valuations, as different asset classes and sectors get thrown in together. But this often creates opportunities for traders.

To see what I mean, take a look at the following charts (these are not trade recommendations).

The first chart shows the SPDR S&P Regional Banking ETF (KRE). It’s an ETF comprised entirely of regional banks.

No surprises here with its dramatic fall as the SVB story unfolded…

SPDR S&P Regional Banking ETF (KRE)

Source: eSignal

Yet it’s not just regional banks that have been marked down heavily.

Increased uncertainty has spread into a wide range of other stocks and sectors like the Financial Select Sector SPDR Fund (XLF).

Check out XLF’s chart…  

Financial Select Sector SPDR Fund (XLF)

Source: eSignal

As you can see, last week’s action looks almost like a mirror copy of KRE’s.

Although panicking investors may be tempted to lump KRE and XLF together, their components are actually quite different.

While 100% of KRE’s holdings are in regional banks, only one-third of XLF’s total holdings are in banks.

And it holds big banks at that. For example, J.P. Morgan, Bank of America, and Wells Fargo combined represent around 21% of XLF’s total holdings.

Beyond its 32% in banks, nearly half of XLF’s total holdings are in Capital Markets (27%) and Insurance (21%).

However, much like KRE, the market has also heavily marked down XLF due to the collapse of SVB. This shows how a stock or sector can get mispriced in relation to another.

But there lies the opportunity.

The key is to identify and capture these mispricing events. And it’s important to be nimble and understand the exact risk you’re taking on.

Always Understand Your Risk

When I want to trade mispricing opportunities, I use options.

If I buy a call option in anticipation of a bounce (or put option for an expected fall), I know the exact risk I’m taking on… It’s the price I pay for that option.

Knowing a clearly defined and quantifiable risk before I place a trade is a key part of my risk management strategy.

Another part of that strategy is risking no more than 2-3% of my total capital on any one trade.

But beyond that, we also need to remember that when volatility is high, a profitable trade can turn into a loser in an instant.

So, if we get our trade right, we need to quickly bank our profits when we see them.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

Reader Mailbag

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I so appreciate the One Ticker Trader. I have had success using Larry’s buy and sell alerts. I have been able to buy options cheaper than Larry’s alert price and I also have been able to sell those for a higher price than Larry’s sell alert price.

– Rick T.

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