Options Update: Contagion Risk

// Options Updates, By John Napolitano | Options Boot Camp

Contagion Risk: Something we haven’t seen in a while reared its head this week.  Will we see other smaller (or even scarier, bigger) banks fail?  

Although Silicon Valley Bank is considered regional, and its collapse may draw a few “so what’s” out of many, here is why its failure is very important:

First, my take on the events this week is fairly straightforward.  I believe where there is smoke, there is usually fire.  

I find it difficult to believe given that many small to medium banks have similar lending standards, that there will not be other bank solvency concerns in the days and weeks to follow.  

Although the banking industry has gotten more regulated since the financial crisis of 2008, larger banks were the primary focus as the “too big to fail” concept became reality.  Regional banks often had lower hurdles and stress tests.

Second, its failure is beginning to illustrate another reality that is a bit scarier.  That is most new tech businesses, particularly in new areas of tech such as AI, will oftentimes fail. 

On top of that, regional bankers may not have the venture capital savvy to differentiate between the good and the terrible.  

In other words, they are lending out YOUR money that you deposit with them out to businesses that they do not fully understand.  

Sound familiar? I’m sure very few regional bankers could dissect for you what the inner working of a CMBS note was in 2008.  What could possibly go wrong now?! 

Lastly, it does have to make you wonder if ANYBODY fully understands these businesses, they are lending money to.  

Given the rapid loss of confidence in SIVB and the KBE (regional bank ETF) getting walloped this week, my guess is investors are beginning to catch on.  

Contagion risk is either brought on by fear (like European indices after the war in Ukraine broke out), or fact (insolvency), the latter obviously the longer to recover from.

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Contagion risk in full view (above) if you look at the performance or the KBE ETF that tracks regional banks.

This stock is still trading, which might present a great opportunity as more bits of truth begin to surface.

Besides the events of SIVB last week, there were two other major things that occurred to cause me to shift from cautious bull to more bearish.  

Powell’s language before Congress gave market participants nothing to hang their hat on besides higher rates for a longer period of time.  Although markets didn’t react horribly right away, it did bring on a more bearish and defensive tone.  SIVB was the nail in the coffin.

The second event was the employment data this week which came out very mixed, but fully illustrated the Fed’s concerns that the economy was not quite cool enough to begin easing up on the gas pedal of rate hikes.

So overall, three new pieces of bad news, and no good news.  What do we do from here?  

We have to remember that as traders, not investors, we can profit from any direction as long as we have the humility to recognize a change in direction.  To me, the SPY below the 50 SMA tells me one thing:  Get more bearish.  

If you have a “long bias” like many traders do, I would consider sitting on my hands this week, bottoms are ugly and given the VIX’s lack of enthusiasm so far, the bottom may be far from in. (see below).

If you are “market agnostic” like me, I plan on shorting any rallies in the financial and real estate sectors, as well as taking early profits on bullish trades and reducing exposure I might have already stepped into last week.  

Any new bullish trades will most likely be in the tech space, particularly semiconductors, which seem to be somewhat of a bright spot in an otherwise dreary looking picture.   But these trades will be in the form of “wimpy” credit spreads or diagonals in the options market.

In conclusion, we may not have seen the end of regional banks’ headline risk, and combined with no encouraging data to speak of, going more on the bearish side is what is in front of us, not necessarily what we wish. 

Look for CPI on Tuesday to either seal the deal or provide a slight respite to the contagion story this week ahead.

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