Long gone are the days when bank stocks were safe investments. Now, and for the foreseeable future, the only safe way to play banks and financials is by trading them.

Banks face so many issues, both in the near term and on a long-term secular basis, that putting shares away, even now when they look cheap, could be hazardous to your wealth and your mental state.

On the other hand, precisely because many of the headwinds banks face are obvious, closely following the developments affecting banks can lead to profitable trading opportunities. And, by familiarizing yourself with how bank stocks trade, you’ll be in an excellent position to determine exactly when they’ve become good long-term holds.

[ad#Google Adsense 336×280-IA]As a trader, I’m always looking for sectors and stocks where developments affecting earnings and profitability are mainstream news. It means I don’t have to mine mountains of arcane data to get the big picture. And right now, all the news coming out about banks makes them ripe for trading.

Here’s what I look at and how I would trade bank stocks.

Banking on Volatility

The first thing I see when I’m looking at banks is that most of them have been exceptionally volatile. Volatility is the lifeblood of trading. They’ve definitely got that going for them.

The most common measure of an individual stock’s volatility is how it compares to the volatility of the market as a whole. Beta measures how volatile a stock is relative to the Standard & Poor’s 500 Index. A beta of “1” means that the stock is as volatile as the market. A beta of “2” means the stock is twice as volatile as the market.

Here are some betas for bank stocks you should consider as good trading candidates: Bank of America Corp.’s (NYSE: BAC) beta is 2.76; Citigroup Inc.’s (NYSE: C) is 2.89; Wells Fargo & Co. (NYSE: WFC) 1.78; Morgan Stanley’s (NYSE: MS) is 1.10; JPMorgan Chase & Co.’s (NYSE: JPM) is 1.43; and Goldman Sachs Group Inc.’s (NYSE: GS) is 1.26.

There are many very volatile European banks to trade, too. But these are even riskier. Personally, I don’t like unanticipated volatility. I like to understand what is happening, what developments are ebbing and flowing to generate volatility.

With the banks, there’s a fairly long list of negative headwinds, which is where their e mbedded volatility comes from.

Big Questions For Bank Stocks

U.S. banks, and even more-so their European counterparts, are facing some very big issues. Each hurdle is big in and of itself, and collectively they form a tremendous weight on the sector.

The biggest question marks are:

  • Unanticipated Expenditures: What litigation and potential settlement costs are banks facing over mortgage putbacks? And what will taking back huge quantities of failing mortgages onto their books do to their capital reserves, ratios, and set-asides?
  • Losing Loans: With the economy potentially slipping backwards, what impact will low loan demand have on future earnings, and are banks damaging their traditional loan businesses by keeping borrower standards higher than justifiable?
  • Fed Intervention: How is the current manipulation of interest rates (they’re being kept artificially low) affecting banks now; what will Operation Twist really do for banks; and what will happen to banks when rates eventually start to rise?
  • Regulatory Reform: What are the major regulatory impacts banks are facing, from the pending Volcker Rule to Basel III capital requirements?
  • European Exposure: What exposure do our banks really have to their teetering European counterparts; how interconnected is the global financial system, really?
  • Sleight of Hand: What accounting games are being played by all the big banks?

Let’s take a quick look at some of these issues to see how they impact banks.

A Wary Investor is a Wealthy Investor

Earnings for the third quarter have been coming out lately, and they’ve been a mixed bag. However, there has been one apparent trend: Every bank has posted better earnings than they otherwise would have because of an accounting trick.

Such tricks are known as debt valuation adjustments.

As a bank, you are going to have a lot of outstanding debt. To hedge against your own debt and the bonds that you’ve issued declining in price, you would buy insurance in the form of credit default swaps (CDS) on your own debt. The thing is, as your bank becomes weaker in terms of its future prospects, its debt prices fall. But since you bought CDS insurance on your debt, its value has risen and you can book that temporary profit in your favor.

There’s another angle to this accounting game, too. Since your outstanding debt is cheaper in the market, but you owe the face amount, if you were to buy back your debt at these lower prices you could retire more expensive debt and book a theoretical profit.

Goldman Sachs booked a $450 million gain from debt valuation adjustments in the third quarter, and it still had an ugly loss. I imagine they didn’t want to make it worse than it was. Morgan Stanley, on the other hand, had a good quarter; at least it looked that way. But Morgan Stanley booked a gain of $3.4 billion from DVA (debt valuation adjustments) bookkeeping. So, while it showed that it earned $1.15 per share, without the DVA sleight of hand, the number was closer to $0.02 per share.

My point is, when trading bank stocks around earnings season, make sure you take a hard look at their numbers. Look under the covers and don’t trust the first headlines that trumpet their numbers. They are true, and people initially react to them, but when smart traders look into the numbers you see a lot of repositioning.

Another potential pitfall is litigation. The mortgage business got banks into a ton of trouble. And they’re not nearly out of the woods. Keep up on who is suing who, and for how much. The numbers are huge and will have an impact on earnings, profitability, banks’ future prospects, and, of course, their stocks.

Additionally, regulatory issues are plaguing banks. You really have to work to keep up on these changes because they’re not yet written in stone, and banks are fighting them all the time. Mostly, I’m referring to elements of the Dodd-Frank Act, including the Volcker Rule – a draft of which has been put out for public comment – and Basel III, international capital standards and regulations.

To really understand how changing rules and regulations will affect banks and their earnings, regularly search for the latest articles available about all these important rules.

You also have to stay on top of central bank policy.

Interest rates are always critical to understanding how to trade banks. You have to understand what current policies are, as well as their potential impact, and you have stay ahead of policy changes and their resultant consequences. Again, you don’t have to have an economics degree, just read up on both sides of every policy decision, because most of the time there are no “right” answers, only opinions.

And as far as global exposure and interconnectedness, bank stock traders have to watch what’s going on in Europe. U.S. banks have been trading off every bit of good and bad news that comes out of Europe. Stay on top of events transpiring abroad and you’ll enjoy lots of exciting and profitable trading.

Beating the Banks at Their Own Game

Because of all the headwinds, I mostly trade banks from the short side. I will short them directly or buy puts at least three months out, and, depending on the leverage I want, I’ll buy at- the- money puts or way out- of- the- money puts.

I always take profits when I’ve reached a good number. Sometimes, because of the volatility of banks, you can get a very good profit very quickly. I usually take it then.

However, if what you’ve been anticipating looks like it’s happening and you are on the right side, I’d take a profit on half of my position and let the other half run, but have a stop loss in mind that still gives you a good profit from where you got in.

Always limit your losses to what you can easily stomach and afford. Don’t forget, this is trading, and when there are lots of trades to make, there will be losers as well as winners.

That said, I also buy some bank stocks after I’ve taken a nice profit on their fall. Because there are a lot of traders shorting banks, when any good news comes out, or after a particularly hard fall, sometimes there’s a bounce back reaction. I take long positions with very tight stops to catch some of these moves, and very often, they, too, are quite profitable.

So, if you think bank stocks are a good buy, you may be right. Just don’t fall in love with them. And, if you think bank stocks are fool’s gold and you want to short them, go ahead. Just remember to keep up on what’s making bank stocks so volatile, and you’ll become very adept at trading them, eventually investing in them when you know the dust has settled and they’ re on the road to long-term recovery.

— Shah Gilani

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Source:  Money Morning