Traders buying calls for a quick pop in this medical device name rather than owning shares outright
Earnings season kicked off in earnest with several major banks reporting since last Friday. Let's discuss what's going on with the financial sector first and then I want to highlight a trade being made ahead of a particular volatile company's earnings report out later Thursday. In theory the set-up for banks isn't terrific. Some banks, most notably Bank of America (BAC) have considerable losses in their held-to-maturity book. This is largely the result of the bank purchasing long(er)-dated Treasuries which have since declined precipitously in value as interest rates have risen. As a reminder, banks held-to-maturity (HTM) accounting records the amortized cost of securities, reported as noncurrent assets, for those securities the bank intends to keep until maturity. This differs from "available for sale" which are marked to market. Explaining the issue with banks BAC's HTM book reached an all-time high for Q3 2021 of over 683 billion. The value of the HTM book has since fallen to $603 billion for the quarter ending in September. To date, Bank of America's unrealized losses have reached nearly $132 billion as rising interest rates lowered the value of the bonds the firm holds. There are different ways to put this into context, but the unrecognized loss, due to the accounting methodology, represents effectively all the income earned in the past couple years. This dynamic may help explain why the bank is trading at 8 times forward earnings. Shareholders realize that all of the income the bank is reporting is largely offset by what are, essentially, unrecognized losses on the asset side of the balance sheet. There is a rationale for the accounting practice, and in some ways it is real for them in a way it isn't really for anyone else. Banks have the privilege of being able to use their Treasury securities as collateral at the Fed window at par. Essentially they can borrow 100% of the face value of the bonds even though the market value may be considerably lower. That's the good news, because it means that they aren't forced to realize a loss by selling assets to meet liquidity needs such as demand deposit withdrawals, for example. It also means that if there is significant credit demand at rates higher than that the Fed charges, they can earn a spread. The bad news is that if one uses a long bond earning 3% against a Fed window loan at 5% and use the proceeds to meet withdrawal requests, the bank is now in a 2% negative carry trade. Ouch. Also, any opportunity to lend must come at a spread greater than the the negative carry to turn a profit. Lending at 3% and using the collateral to borrow at 5% to turn around and lend the proceeds again at 7% begins to look a bit like the First CityWide Change Bank skit from Saturday Night Live where a bank's entire business doesn't appear to have any economic benefit for the bank. XLF SPY 5D mountain S & P Financial Select SPDR vs. S & P 500 SPDR Trust Despite this grim picture though, financials have actually been a relative bright spot since the banks started reporting earnings a few days ago. Despite a slight decline in the S & P 500 since Thursday's close, the financial sector is essentially unchanged as I write this. Risk premiums, as implied by options prices on Financial Select SPDR (XLF) vs. SPDR S & P 500 ETF Trust (SPY) , have also narrowed. Put differently, two weeks ago a 2.5% out of the money put on the XLF would have cost 20% more than a comparable put on SPY as a function of the underlying share price. Today, even with considerably higher geopolitical risks, that premium is only 10% greater. Put prices on the S & P 500 are slightly higher and put prices in financials are slightly lower. Even the best of the money center banks, JPMorgan, has underperformed the S & P this year, and BAC, the worst of them, is down over 15% year-to-date. The softening risk premia and relative strength we've seen over the past several days may indicate that most of the damage is done…for now. Earnings after the bell Looking ahead to some notable names that have yet to report, Intuitive Surgical (ISRG) is scheduled to report earnings Thursday after the bell. Right now the options market is implying a move of greater than 6.6%. This is above the 10-plus year average earnings related move of 5.5%, but below the 7.2% earnings moves seen over the most recent two years. Intuitive is up over 42% over the past 12 months, but only 3.8% of those gains came this year. The consensus view is for 1.42 in adjusted EPS on just under $1.8 billion in revenue, according to FactSet, which would be increases of 19% and 13.5% respectively year-over-year. ISRG 1Y mountain Intuitive Surgical (ISRG), 12 months Call volume was slightly above the 20-day average and put volume slightly below. That combined with Wednesday's outperformance suggests that investors are leaning slightly bullish into earnings. The most active contract, the October $285 calls, traded 445 contracts (44,500 shares worth) at an average price of $6.26/contract. Buyers of those calls are risking about 2.3% of the current stock price on a bullish bet that the stock could rally through week's end. ISRG would need to move 5.9% higher over the next two days just to break even on those calls, and they have a relatively low 32% probability of profit for the buyer. That said at over 44 times forward earnings, a relatively high 1.3 beta, and looking weak on most technical indicators other than short-term relative strength/envelope type strategies such as Relative Strength Indicator, Bollinger Bands et al, one can understand why some investors are buying calls rather than the stock, which, as it happens, is how we are positioned in our event-driven long-only ETF. 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