How to make a deeply out-of-the-money market

[paradigm]

My statements are not intended to critique your analysis and assumes you are correct, so just trying to provide another perspective.

Is your time horizon actually 2 years or could it be 2.5 or 3? It wouldn't be so pleasant to put your entire $10k in to options that will expire in 2 years only to see the crash happen 3 months later.

As ironchef already noted, once other investors wise up to the impending doom, the puts are going to become quite expensive. That they're not now means you're ahead of the curve. In order to get a good price on the puts, you need to open your put position on before everyone else realizes there's a massive problem. Waiting gives you the benefit of being able to extend out the time horizon for the crash, but has the risk that everyone else will realize it's going down and the puts will be more expensive. As long as you're still ahead of other investors, you'll get a good price, but since you're not finding liquidity in expirations 2 years out, waiting until it's not so far away may bring you liquidity and/or better prices (or at least a fill). Just another perspective on how to approach.

I do agree though that the bank going down will be a systemic. Do you have sector based ETFs or other indices in which you may be able to find better liquidity, but will also take a massive hit? What I mean is, if this banking stock goes down, will it cause an issue with other banking stocks? If so, a banking index or ETF might be worth looking at. How will exchange rates be affected? Will CBA failing cause another company, with possibly a more liquid options market, to also fail or be substantially impacted? For example, if this bank fails, then other businesses that rely heavily on debt will probably have a very difficult time getting capital to operate their business (even from other banks), so they may also take a large hit.

If what you're saying is true, that the housing market, exports, etc is all going to be a problem, I think it's wise to look at everything that may be impacted rather than focus on a single stock (particularly because the market isn't giving you what you want -- low strike, long dated, cheap puts), so you should look at alternative methods to capitalize on the same thesis.

Good luck.

Thanks for your reply.

I need to think about the strategy itself a bit. I have a couple of ideas that I will work through and see if they make sense.

I like puts because of their properties, especially the limited risk, and leverage.

I am aware of some other shorting mechanisms. There are inverse ETFs on the ASX which are funds holding cash and futures against the ASX200 index. There are two that I know of inverse leveraged at 0.9-1.1 and 2-2.75. Another way would be gold to short the AUD. Short selling but this is too risky for my tiny amount of capital. Holding cash and just waiting.

 

[ironchef]

I really like your thought process, you want to replicate "The Great Short"?

Instead of thinking about the strategy, I suggest you should analyze your conclusions more thoroughly: Are there indeed a structural issue in Australian housing? Are the banks indeed over stretch? Are there any real risks in those mortgages (e.g., US subprime and reckless MBS).... Make sure you are indeed correct.

Also, like the other poster said, timing is critical, too early or too late will not work since you have limited resources whereas the market can stay irrational a lot longer than you may think.

Regards,

 

[sle]

CBA PEARLS are, from their prospectus: "subordinated unsecured notes"

I also find it strange that they call them PEARLS when there is already another investment type commonly referred to as PEARLs that I believe has a better risk profile than these hybrids.

These things, right: https://www.commbank.com.au/about-us/shareholders/securities/perls-vi.html ?

 

[JackRab]

I am away from my Bloomberg (really away, like 1000 miles), but aren't these exchangeable for common stock like convertible preferred stock, but subordinated in case of default (so better then preferred stock, but not a senior debt either)?

No time or interest to read the whole prospectus.... So not sure, but if they are... then it would be upon the company to do it... They are callable, again CBA has that right, not the holder.

They are in effect worse than stock, since they have no voting rights.. are subordinated, do pay out a decent interest (or dividend if you will) but I'm sure there's a line somewhere in the prospectus that will state that in certain scenarios CBA can opt to not pay interest/dividend.

So again... not amazing, maybe when they trade way way down... but not current IMO.

They are probably called PEARLS since it's nice and catchy... they could've named them CBA-DOGSHIT... but I doubt that would sell very well...

 

[JackRab]

I really like your thought process, you want to replicate "The Great Short"?

Instead of thinking about the strategy, I suggest you should analyze your conclusions more thoroughly: Are there indeed a structural issue in Australian housing? Are the banks indeed over stretch? Are there any real risks in those mortgages (e.g., US subprime and reckless MBS).... Make sure you are indeed correct.

Also, like the other poster said, timing is critical, too early or too late will not work since you have limited resources whereas the market can stay irrational a lot longer than you may think.

Regards,

I'll chime in on this...

- structural issues, yes... but too much? Compared with London/NYC/HK/etcetc... no, it's similar... big cities everyone wants to live in are expensive... and they will always be expensive.
- overstretched banks, yes... as always the case when there are only a few major ones that do most mortgages... all banks are overstretched when there's a bankrun combined with big drop in housing and defaults
- risk in those mortgages, yes... IMO there are lots of investors that shouldn't hold massive property portfolios. There are always stories about how a plumber and teacher hubby/wife, under 30 years old, have a 5-8 mln portfolio... so yes... that's fucked...

But, it's not like you can just leave your house keys and walk away debt free in case of default.
Also, most housing in Australia is very focussed on the big cities... there just isn't that much sprawl compared to US IMO. And cities usually do fine, especially the ones like Sydney/Melbourne.

So in short, there are issues... but I doubt it's going to really hurt. If the market "crashes" 10 or 15%, that's covered by equity (most if not all mortgages have 10-25% equity demanded)... and that's just the gain in the last 2 years...

 

[sle]

No time or interest to read the whole prospectus....

I just did. These things are about as pleasant as a hot poker up my arse.

 

[JackRab]

I just did. These things are about as pleasant as a hot poker up my arse.

Still a little bit of free time eh?

Did you do all that from the tent???

 

[sle]

Still a little bit of free time eh?

Did you do all that from the tent???

Actually, read it right before the drive back. Interesting product (AKA, a nice way to f*ck your investors)

 

[JackRab]

Actually, read it right before the drive back. Interesting product (AKA, a nice way to f*ck your investors)

Yep... but I'm almost certain every bank world wide has those to sell in some form or another... and other large companies. They've been around....

"One of the oldest examples of a perpetual bond was issued in 1648 by the Dutch water board of Lekdijk Bovendams" (from wiki)

 

[sle]

Yep... but I'm almost certain every bank world wide has those to sell in some form or another... and other large companies. They've been around....

"One of the oldest examples of a perpetual bond was issued in 1648 by the Dutch water board of Lekdijk Bovendams" (from wiki)

Perpetual bond aspect is not a problem. It's the callable/mandatory aspect that gets you.