Michael Shulman

Banking on Short-Side Profits

by Michael Shulman   09/10/08

I like to use past trades to illustrate how you can make money on new recommendations -- and my favorite is a very successful short position based on problems with Citigroup and the entire banking sector.

The performance of the financial sector is often a harbinger of how the rest of the market will trade. When the banking stocks are doing well, the market typically finds itself in an uptrend. But when the lenders are the ones finding themselves with empty pockets -- and, in turn, their stocks start to slide -- it's not uncommon for the broader indices to tumble as well.

The subprime-lending mess was accelerating last fall, when I was sitting in the "green room" at Fox Business. The room isn't actually painted green, mind you, but this is the common name for waiting rooms for TV shows. In any event, this particular room ended up making my subscribers a lot of green, so the name is pretty appropriate!

In the green room that morning was Meredith Whitney, a brilliant analyst with Oppenheimer, and she had just put out a "Sell" rating on Citigroup (C). This had led to death threats and an appearance on Fox that morning.

We went over some gruesome numbers, and although Wall Street didn't like her outlook, I could see exactly where she was coming from. When I got back to the office, I looked at more and more data on Citi, and it was clear to me that the company needed to shed assets and cut their dividend -- and that shareholders weren't exactly going to be receptive to it when it happened.

So, I decided to not only short this bank -- but also the entire financial sector -- through buying put options on Citi as well as on the XLF, which is an Exchange-Traded Fund that represents the banking sector.

Although market volatility is a short-side investor's best friend, as it can help falling stocks to go down even more quickly than they already were, sometimes a market sell-off can become our worst enemy, particularly when we're trying to establish new put-option positions at a time when premiums are soaring.

Such was the case in mid-November when we were establishing these positions. We got into the XLF March 28 Puts relatively easily at $1.44 apiece, but we had to wait for a couple of days for the Citibank puts to trade down to a reasonable entry price.

I issue Buy Under prices with each recommendation to ensure that my subscribers get the best-possible risk/reward scenario. This means that if we keep our cost basis low, then the higher the option trades, the better our profits can be. And if the trade turns against us, that also means the less we can lose.

As I mentioned, Citi was not an easy trade -- the puts were bouncing around -- and we waited a bit waited a bit more and then got in, buying the June 30 Puts at $2.15. This was a bet that shares, which were worth $35 at the time, would slide below $30.

Our patience was rewarded just two months later when we closed the puts at six bucks – a near-triple!

Meanwhile, our XLF put -- which was a $1.44 bet that this $31-a-share ETF would drop below $28 -- paid off for us in the same time frame.