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Options Trading: How to leverage market volatility into profits

Posted February 8, 2008
A Today’s Financial News Research Report:
“Best turn-around options trading play: Buy ETFC January 2009 $5.00 Calls (ONY AA) for under $1.40. If ETFC trades up to $7.00, these calls could move up to $2.70, good for a 92% gain.” – Bryan Bottarelli

By Bryan Bottarelli, Editor, Bottarelli Research

Today’s Financial News feed provides an independent and practical perspective on the U.S. and global investment markets.
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This report is discussed in this week’s TFN Smart Trading video. Watch it here.

Baltimore (TFN): When trading options, the key to winning speculation is to risk as little money as possible to make the biggest return. And that perfectly describes the opportunity I’ll be presenting you today.

For starters, let’s look at the stock movements of some of the top mortgage lenders. On July 10th 2007, Fannie Mae (FNM – NYSE) closed at $66.49. Today it trades for $34.34, good for a 50% loss.

Also on July 10th 2007, Countrywide Financial (CFC – NYSE) closed at $37.34. A week ago, it traded for $5.01, marking an 87% loss.

In short, two of the biggest mortgage lenders in the country have lost 50% and 87% of their value since July 10th. Now remember, CFC and FNM are companies with business models based entirely on lending. The have been exposed to the full brunt of the subprime meltdown and collapse of the US real estate market. You could argue that their valuations are true reflections of the companies perceived and real valuations in the current broader market.

Options trading allows you to liberate

Now let’s consider E*TRADE. On July 10th 2007, E*TRADE Financial (ETFC - Nasdaq) closed at $ 22.93. This week, it traded for $4.38, giving it an 81% loss! In fact, this was E*TRADE’s lowest level since 1996 – making them the worst performer on the entire Standard & Poor’s 500 index!

When I see a reaction like this, I can’t help but think that Wall Street is treating E*TRADE like a mortgage lender – not an online stock broker. Now I admit, the company got caught up in business segments that hindsight states they should not have been involved in – notably the sub-prime lending sector. And as a consequence, the stock is paying dearly.

But as I write you today, there is a good chance that all of the bad news has now been factored into the stock. In fact, when E*TRADE reported Q4 earnings on January 24, they unveiled full details of their new restructuring plan aimed at reducing balance sheet risk and lifting shares off their all-time lows. In fact, some rather important moves have already been made.

In November, for example, ETFC sold a portion of their mortgage portfolio to Citadel Investment Group and secured a $2.55 billion cash infusion. This sale included a combination of mortgage securities and municipal bonds, and substantially reduced their debt levels. E*TRADE also recently sold $3 billion of mortgage-backed securities and municipal bonds, which got them off the hook of these obligations for the manageable loss of just under $5 million. Not only that, but they’ll also exit their institutional trading business – which means E*TRADE will solely focus on what they should’ve been focusing on all along: Their retail banking and brokerage operation.


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This re-focus is once again attracting investors to the stock. Since hitting a low of $2.08 on January 8, the stock has rallied all the way up to over $5 in late January. That’s a 150% gain! And considering the stock’s $23.00 price in July of 2007, the potential gains are far from over.

I feel that a re-commitment to their online brokerage business – combined with the elimination of their troubled business operations – could be all it takes to spark a turnaround in the shares. Heck, all you need is the stock to move up to $7.00 and you’ll have a 58% gain on your hands. You could easily see this type of reaction in the first 3-6 months of the year.

Think that type of upside move is impossible? Well, consider this comparison…

E*TRADE has a P/E ratio of 2.82. That is ridiculously low when compared to Charles Schwab’s P/E of 11.59 and TD Ameritrade’s P/E of 18.00. E*TRADE’s Price-to-Sales ratio of 0.48 also looks ridiculously low compared to Schwab’s P/S ratio of 5.53 and TD Ameritrade’s P/S ratio of 5.51. Plus, in terms of profitability, E*TRADE’s trailing three months revenues of $2.11 billion actually came in higher than TD Ameritrade’s three months revenues $2.06 billion!

When you see valuations like this, a $7.00 price target seems very reasonable. After all, if E*TRADE can get their current valuations to just half of those of TD Ameritrade or Charles Schwab, then ETFC could quickly jump 50% to 100% by Q3 2008. That’s why I feel it’s worth a shot to add a small position at these levels.

Now remember, this is a pure “recovery” play that has the ability to jump rather quickly.

And therefore, the best way to play E*TRADE is using longer-dated call options. One of the very best “speculative” plays you can make right now is buying the ETFC January 2009 $5.00 Calls (ONY AA) for under $1.40. If ETFC trades up to $7.00, these calls could move up to $2.70, good for a 92% gain. For only $1.40 per contract, I feel that’s well worth the price!
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