The Striking Price

How to Profit From the Coming Rate Rise

Consider using options on a basket of 12 financial stocks in anticipation that rates may rise by January 2018.

By STEVEN M. SEARS

Saturday, September 17, 2016

Many investors believe that any interest-rate hike, no matter how small, will be bad for stocks and the U.S. economy. They worry that stock prices will decline, and economic activity will slow, if the Federal Reserve abandons the easy-money policy that it initiated in response to the financial crisis.

On the other hand—and this brings to mind President Harry Truman’s ardent wish for an economist with only one hand—some investors contend that a rate hike will actually benefit stocks. After all, the Fed would raise rates only if the economy were healthy, which would mean conditions are ripe for corporate profits to rise.

The market mob has vacillated between those two opposing views for more than a year. Some might even blame the market’s recent gyrations on that debate. At some point, a definitive answer will emerge—perhaps this week. The Federal Open Market Committee concludes a two-day meeting on Wednesday, though the chances of a rate hike that soon have recently eased.

Rather than trying to pinpoint the next rate hike, Goldman Sachs is telling clients to consider investing in a basket of 12 stocks in anticipation that rates may rise by January 2018.

The favored names: Charles Schwab (SCHW), Comerica (CMA), Zions Bancorp (ZION), TD Ameritrade Holding (AMTD), Bank of America (BAC), Citizens Financial Group (CFG), Regions Financia l (RF), State Street (STT), Bank of New York Mellon (BK), JPMorgan Chase (JPM), Northern Trust (NTRS), and Raymond James Financial (RJF).

If rates rise to 3%, the bank’s financial analysts anticipate that the group’s earnings will rise by an average 46%. Higher rates tend to lead to higher profits for banks. Though options dealers are most certainly aware of that fact, the options market seems to be missing, or entirely discounting, the potential for a rate hike to benefit those 12 stocks, according to Katherine Fogertey and John Marshall, Goldman derivative strategists.

The strategists are thus advising clients to buy six- and 12-month call options on each of those rate-sensitive stocks in anticipation that stock prices may rise into 2018.

By selecting longer-dated options, investors expose themselves to all of the FOMC’s announced meetings. This includes this year’s meetings in September, November, and December. It also includes next year’s meetings in January, March, May, June, July, September, October, November, and December. The 2018 calendar is not yet available.

Any contract that covers so many major events—and particularly for the financial sector—would intuitively seem priced to reflect heightened odds that stock prices might change in reaction to decisions. Yet these 12 stocks appear mispriced.

Fogertey and Marshall say that the basket’s term structure—similar to the bond market’s yield curve but just for options—is significantly flatter than the Standard & Poor’s 500 index and many of the index’s stocks. This suggests that the options market is not yet differentiating between stocks that benefit from rate hikes and those that do not.

Consider Schwab as a potential template for structuring rate-hike trades. With the stock around $30, the March 34 call is trading around $1.25 and the January 37 call is trading around $2.05.

At $37, the March call is worth $3. At $41, the January call is worth $4. Over the past 52 weeks, the stock has ranged from $21.51 to $34.52. Should the stock price be lower than the strike price at expiration, the trades fail.

If rates rise soon, the March call will probably see a nice boost in value. This reflects the proximity of the expiration to any event. The January call is less sensitive to more distant news, but it literally buys time, which may prove to be an important ally of anyone trying to time rate hikes.

Reprinted by permission of Barron's Online, © 2016 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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