Straddling the Brokerage Sector

A Fed-Induced Play

Dear Bottarelli Research Member,

Going into tomorrow’s Fed meeting, it’s prudent that we keep a light trading ledger. After all, the economic experts are split 50/50 on whether the rate cut will be 25 or 50 basis points, and a coin-flip scenario like this are odds that are not stacked in our favor. Further complicating the situation is the fact that the Dow has moved aggressively higher, tacking on 900 points over the last 10 trading days. Check it out for yourself:

Coming into a critical Fed decision on the heels of this powerful upside move, it’s easy to make the argument for a pullback no matter what happens tomorrow afternoon. From a technical perspective, the Dow’s ability to pop above its 50-day moving average in today’s session is certainly strong — but all bets are off come tomorrow. So once again, I’ll reiterate my position, which will be to keep a light ledger leading into tomorrow.

Since we locked in gains in our DRYS calls this morning, we’re left holding a longer-dated January position on the CG January 90 Calls (CG AR). Let’s continue to hold this position, but at the same time we’re once again faced with a very interesting situation on Lehman Brothers (LEH – NYSE).

As you can see from the chart, LEH has moved up over the last few sessions, but it’s once again approaching the 200-day moving average (in red) which has acted as a solid resistance level for many months. This resistance level, combined with any Fed-induced volatility, could push shares of LEH lower tomorrow. Also working in our favor is the fact that LEH announces earnings on December 13^th (which is this Thursday). This could be yet another trigger for large intra-day price swings.

At the same time, we have Goldman Sachs (GS – NYSE) currently stuck within a very tight trading range — contained using the 50-day moving average at the top and the 200-day moving average at the bottom. Now here’s the thing: If GS can break to the upside, sparked by a strong reaction to the Fed, you could very well see a re-test of their $250 high from late October.

In other words, the LEH chart looks weak and the GS chart looks like a potential breakout could be looming. And with tomorrow’s Fed announcement as the catalyst that could spark either directional move, anything could happen. So what I’d like to do is take a very small put position in LEH — and combine this with a very small call position in GS. This will effectively create a brokerage straddle position — one which turns a profit as long as we see a sizable upside or downside move in tomorrow’s tracing.

If you decide to make this play, then I’d like you to play it light (meaning buy less contracts than you normally would). And of course, maintain an equal ratio by buying one LEH put for every one GS call. Given that set-up, here’s the combo play:

PLAY: Buy the LEH December 65 Puts (LES XM) at or under $2.90, good for the day. Current bid/ask spread is $2.65 to $2.75.

PLAY: Buy the Goldman Sachs December 240 Calls (GPY LH) at or under $2.90, good for the day. Current bid/ask spread is $2.50 to $2.70.

Since these are off-setting plays, do not place a stop loss on either position at this time. Rather, think of the combined value of each option contract as your total position. For example, we’re paying a total of $5.80 to carry GS calls and LEH puts. As long as we sell the combined basket of LEH puts and GS calls for more than $5.80, we’ll be in the black.

Now remember, this play is predicated upon volatility. So long as the market’s reaction to the Fed offers a market reaction of substantial magnitude, this combination of LEH puts and GS calls will help you come out with a profit on the total basket.

*Tactical Note: Aside from the Fed tomorrow, this call/put position also offers two more aces in the hole. For example, LEH announces earnings on December 14^th and GS announces earnings on December 18^th. So in addition to the Fed catalyst, we also could see large price swings heading into each earnings announcement.

So, given the current status of the markets, I feel comfortable holding a protected call/put position such as this. So let’s enter each position leading into tomorrow’s Fed announcement and let the volatility ensue!

And as always…

Lock and load

Sincerely,