Michael Shulman

2 Ways to Short the Banks

by Michael Shulman   11/20/09

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One of my 10 Reasons the Economy Will NOT Recover in 2010 is the continuing credit crunch.

By year-end 2009, we will see a more than $4 trillion pullback in credit lines. And we are a country that runs on credit. In fact, the entire growth in consumer spending from 1997 to 2008 was paid for with home equity lines and credit cards.

In addition, credit standards are already impossibly high, meaning many previously qualified consumers simply can't get it.

The big money-center banks that dominate the sector are heavily exposed to consumer credit, and 2010 is going to be a bad year for them as they continue to feel the effects of the credit crunch.

If you don't believe me, check out Meredith Whitney's CNBC interview from Nov. 16.

I met Whitney on the set of Fox in October 2007, which is when she became famous for her call that Citigroup (C) would have to raise $30 billion by cutting its dividend or selling assets in order to survive.

I walked away from our conversation a true believer.

Why?

Because she is smart, objective and focuses on fundamentals.

In fact, her work prompted me to look at the banks, and then recommend short positions in the money-center banks that made my ChangeWave Shorts subscribers a fortune.

Whitney was also right with her later predictions about Merrill Lynch and Bank of America (BAC), and about the fact that things would get worse in 2008.

And Whitney's recent CNBC interview made it clear that she does not think things will be looking up for the banks in 2010 either. I wouldn't bet against her.

How to Short the Banks

There are two ways to play the pain ahead in the banks.

Rather than trying to guess which banks will suffer the most, you can short the sector by buying put options on the Financial Select Sector SPDR (XLF).

Or, if you can stomach the risk, you can buy call options on the UltraShort Financials ProShares (SKF) -- the double inverse ETF that corresponds to twice the inverse of the daily performance of the Dow Jones U.S. Financials Index. So, for every 1% the Dow Jones U.S. Financials Index falls, the SKF rises roughly 2%.

By purchasing calls on SKF, you're further increasing your leverage. If the financials tumble, you'll be looking at a rocket-fueled trade. But keep in mind that this is also very risky, because the SKF is extremely volatile.

With either trade, I would suggest January 2011 or January 2012 LEAPs, as these are meant to be long-term plays on the sector.

Wait until the financial stocks start to lose some of their current momentum, and then pounce on these options.   

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