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Equity Linked Strategies: Using Options to Play Upside in Regional Banks

Published on June 5, 2023

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Dennis DeBusschere

Brian Herlihy

Kevin Brocks

Sophia Wang

We do not have an edge on what will happen with Regional Banks. Certainly not at a stock level. Many of the regionals are likely still uninvestable given all that is unknown. But the KRE etf as a composite looks like a good options trade here. At some point, the vulnerable banks will fail or recover, and survivorship will make the etf a nice trade (especially since calls are cheap, detailed below). KRE valuations are already discounting pessimistic outcomes.

Management sentiment toward liquidity (availability of cash and credit, measured using the Amenity natural language processor), dipped in 2Q but remains strong overall. There are few signs of cash flow or credit issues across Financials.

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More on the etf as a composite – many of the shakiest banks have underperformed into extremely small weights within the KRE. We built monitors to track the at-risk constituents of the KRE (monitors detailed below). Here we detail the current KRE constituents and weightings, highlighting in dark red the banks that appear on both our monitors and in light red banks that appear on one of our screens. Our screens are conservative, and still, all in, only account for 13% of the etf. Those appearing on multiples screens account for 6% of the etf.

Source: Bloomberg, 22V Research

We are monitoring the banks with the worst p/b ratios, eps growth estimates, liquidity sentiment, equity returns since 3/3, and how they have recovered in the last couple weeks. If you have better screens to monitor conditions at individual banks, please let us know. We welcome feedback. The banks appearing on multiple lists are highlighted in the below table. Their 2-week equity performance suggests some stabilization. HMST is the worst performer, and has a weighting of 0.05%.

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Here’s a detailed look at the worst p/b ratios…

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… the worst eps growth estimates…

… and the worst liquidity scores from the latest earnings releases.

The earnings outlook for regional banks has deteriorated, but the etf doesn’t have to recover all of its losses to make for a good trade. The skew in the etf is heavily to the downside, leaving calls cheap.

We like buying KRE 7/21 $44/$46 call spreads. We prefer structures that have limited downside in case financial conditions deteriorate again from another shock.

Return scenarios are mocked up below.

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Current Ratings Definition.

SECTOR OUTPERFORM: An “outperform” rating anticipates the company will outperform the S&P Regional Banking Index (peer group).

SECTOR PERFORM: A “market perform” rating anticipates the company will perform in line with the S&P Regional Banking Index (peer group).

SECTOR UNDERPERFORM: An “underperform” rating anticipates the company will underperform the S&P Regional Banking Index (peer group).

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