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What options strategies are best suited for investing in the banking sector?

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posted Jul 14 by Amrita

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The covered call option strategy allows investors to profit from the banking sector's stability and its track record for slow growth. This strategy works best with a sector that does not oscillate wildly and is not overly susceptible to market whims. The banking sector, represented by a beta of 0.53, indicating its volatility is only half that of the broader market, offers one of the strongest opportunities to profit by employing the covered call strategy.

Apart from the financial meltdown of 2007-2008, during which U.S. banks suffered an unprecedented upheaval that included the fall of industry giant Lehman Brothers, the banking sector has been characterized by stability and low volatility for most of its history. Those who invest heavily in the sector do not enjoy the aggressive returns provided by highly volatile industries such as tech startups. Except for anomalies such as the aforementioned 2007-2008 crisis, they are also insulated from the high risk endemic to growth sectors.

While the banking sector's stability and slow growth offer investors a way to get rich slowly with minimal risks, shrewd investors employ strategies that use the same stability to generate more immediate returns. The covered call strategy involves selling a call option on securities an investor also owns. The call option gives the buyer the option but does not obligate him to purchase shares at a predetermined strike price by a future date. Its counterpart, the put option, gives the buyer the option to sell under the same terms.

The following is how the covered call works from the seller's end. Suppose an investor owns 500 shares of Bank XYZ stock, which currently trade for $100 each. He sells a 100-share call option with a strike price of $100 and an expiration date a month in the future; his buyer pays a premium for the option.

From here, three things can happen. The share price can increase, in which case the buyer executes the call, enabling him to purchase 100 shares from the seller at $100 each, even though market value is higher. Fortunately, the seller is covered; he already owns the shares, so he does not have to buy them out of pocket to sell at a loss.

The share price can also decrease. In this scenario, the buyer lets the now-worthless option expire, and the seller keeps the premium as profit. A price decrease is not all positive for the seller, though; the shares he owns are worth less.

Then there is the most favorable scenario to the seller: flat movement. The price does not move much at all so it makes little sense for the buyer to execute the option. He lets it expire, and the seller profits on the premium. Even better, since there is no price decrease, the seller's own investments in the security do not decrease in value.

answer Jul 15 by Anushka
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