Pass/Fail Friday: Europe’s Stress Test At High Noon (FAZ, XLF, C, BAC, DIA, DXD)

What a way to end the week! The EU has decided to leave us hanging until the last moment as they hold off on releasing their bank stress test results until after the markets close (11:30 EST) which leads me to believe the results may not be good or they wouldn’t be waiting until the markets are closed and then giving investors the weekend to digest the results. If the tests are good, then the US will rally and Asia will rally and the EU would have to gap open on Monday and that would annoy investors over there (kind of like we were annoyed yesterday). But if the results are bad, then we can drop back to 10,200 or lower and Asia can sell off and they will gap down on Monday but perhaps less of a panic sell-off than if they got hit with the news on a Friday morning.

So, because the results were already delayed and because the ECB has chosen to wait until Friday afternoon, I’m going to have to at least make a small bet that we have a failure. We already hedged the Dow in yesterday’s Member Chat as we weren’t sure of the timing and we wanted to lock in our gains for the week but now let’s look at a nice, profitable way to play a sell-off in the financials.

  • (NYSE:FAZ) is the 3x Ultra Short ETF on the financials and you can just buy that ETF for $14.62 a share and a 3.3% move down in (NYSE:XLF) should translate to a 9% gain to $15.94, not a bad day’s work right there! Thanks to the uncertainty we now have, this trade can be augmented with the sale of the August $14 puts and calls for $2.65 and that drops the net purchase price to $11.97. If (NYSE:XLF) finishes below $14, another round of stock would be put to you at $14 for an average entry of $12.99, which is 12% lower than the current price so this trade assumes the financials don’t go UP 4% by August 20th. If (NYSE:FAZ) finishes over $14 (.62 lower than it is now) the net return on the $11.97 is 17%, not bad for three week’s work…
  • Since (NYSE:XLF) is also $14.45, we can also have some math fun. In theory, (NYSE:XLF) should move 1/3 of what (NYSE:FAZ) moves, so for (NYSE:XLF) to fall 10% to $13 (NYSE:FAZ) should go up 30% to $19. That means we can sell the (NYSE:XLF) Sept $14 puts for .55 and buy the (NYSE:FAZ) Sept $16 calls for $1.52 and sell the $19 calls for .92 which is net .05 on the $3 spread. So, if (NYSE:XLF) falls to $13, you will owe back $1 for the puts (which can be rolled) but the call spread will pay $3 for a nice $2 profit on the .05 laid out (3,900% profit in 2 months). If (NYSE:XLF) does not fall at all, the puts you sell expire worthless and the bull call spread expires worthless and you lose .05. The most you can possibly lose on this trade is $1 but it’s VERY unlikely to happen (more likely we are risking .05 to make $2) vs a $2 reward so a very nice way to hedge financial longs.

Those are a couple of very basic trades. Regulators are scrutinizing banks to assess if they have enough capital, defined as a Tier 1 capital ratio of at least 6%, to withstand a recession and sovereign debt crisis, according to a document from the Committee of European Banking Supervisors. Lenders that fail the trials will be made to raise additional capital. Analysts’ estimates for the amount of capital European banks will need to raise range from 30 billion euros ($38.7 billion), according to Nomura Holdings Inc., to as much as 85 billion euros at Barclays Capital.

We took full advantage of the market gyrations this week with Member Alerts that were profitable in both directions but in yesterday’s 9:38 Alert to Members, we couldn’t resist Valero (NYSE:VLO), Citigroup (NYSE:C), Bank of America (NYSE:BAC) and Apple (NYSE:AAPL) (3 of which I had mentioned in the morning post) and we added a Caterpillar (NYSE:CAT) spread after taking a look at its very lovely earnings. Between those gains and the spectacular gains we made by being about the only people in America buying at the bottom, we had a lot to protect so these hedges are very important. Of course we rolled up our Mattress Plays, which automatically make us more bearish the higher the market gets and we added (NYSE:DIA) $99 puts at and average of $1.01 as well as an aggressive sale of (NYSE:DXD) puts near the close. We also took some of our wild YRC (YRCW) gains off the table and the only long we added after the open was Exxon Mobil (NYSE:XOM) so I can guess you’d say we already flipped a bit bearish into the weekend.

Of course, our base of entry on positions is about Dow 9,800 so 10,300 is our 5% rule and we simply expect a pullback of 20% of the gains, back to 10,200, which means we simply are playing the percentages that we will see a retest of our mid-points (notice I no longer have the confidence to call them bottoms) at Dow 10,200, S&P 1,075, Nas 2,200, NYSE 6,800 and Russell 620.

Obviously, this is a huge data point this morning; getting past this will be key and next week we finish the month with hundreds of earnings reports as well as June Home Sales, Case-Schiller Index, Consumer Confidence, Durable Goods, the Beige Book, Q2 GDP, Chicago PMI and the University of Michigan July Survey. The week after that we see Personal Income and Spending, Factory Orders, Auto Sales, Consumer Credit and Non-Farm Payrolls so I’m pretty confident that we’ll have a VERY good idea of whether 10,200 etc. is a floor or a ceiling by then!

We will certainly have a lot to think about and we’ll have to be fast on our feet as well in today’s trading so I’m cutting this short to get ready with our Members. Asia was good this morning with the Nikkei finally having a good day (up 2.28%) but still miles behind the Dow at 9,430 despite pumping the yen (desperately) back to 87 to the dollar. India was flat but over our goal for the week at 18,130 and the Hang Seng (20,815) and Shanghai (2,572) are both comfortably over their targets as well so we’ll put Asia in the “win” column for now.

Europe was doing well at the open but has dropped back to a flatline ahead of our open (9am) despite a big positive surprise in German business confidence which was backed up by much stronger than expected UK GDP data. It’s going to be a very exciting finish to a very exciting week so let’s all be careful out there – the only big surprise would be NOT having a wild day today.

Written By Philip Davis From Phil’s Stock World

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