Update On Bank Run Plays: KRE

Last week I wrote that the panic over the US banking industry was overblown as evidenced by huge amounts of insider buying, options-market signals, a US government that has little choice but to backstop a banking collapse, and general common sense observations. I said that banking should be fine and mentioned a trade I was personally doing in light of these events—selling puts on the SPDR S&P Regional Banking ETF (NYSEARCA:KRE). This article is a quick update showing a synthesis of new information, how the suggested trade is going, and some thoughts on future trades along this theme.

First, the trade has gone well so far. The puts I wrote expired Friday and I got to keep my full premium. I also sold some extremely far OTM puts on First Republic Bank (FRC) which also expired on Friday. This was mainly because the implied volatility of FRC was over 600% so I figured that the risk-reward made it a positive expected value trade. Position size is what matters here-- the max loss was the strike price times 100 per contract and I was getting about a twentieth of that max loss, and a much bigger chunk of the expended buying power, all upfront. I may consider selling more FRC puts this week, but currently all I have done is sell another tranche of KRE puts.

The thesis that US banking is doing okay still stands. If anything, there are even more catalysts supporting this outlook. For one, banks have borrowed about $300 billion in the past week to help meet demands for withdraws. Much of the borrowing was through the discount window, a program where the Fed acts as a lender of last resort to meet liquidity needs. Although the use of the discount window is often not a good sign, we must bear in the mind the context.

The panic comes from the exceedingly public spectacle of by a few clustered, high-profile collapses due to poor risk management. There is very little that is fundamentally wrong with most US banks. The extent an otherwise healthy bank cannot meet withdraw demand at a time like this is a function of fractional reserve banking. For these cases, use of the discount window does not indicate distress on the banks’ side. What the discount window offers is a way for banks to ride out a period of herd-mentality panic, which is unlikely to last the full 90 days that the discount window credit covers for.

The only real threat to the value of KRE and US banking is if faith is permanently lost in US banks. I don’t see this happening because there is simply no favorable alternative at this moment. What else would people turn to… crypto? Foreign banks? Cash under the mattress? For most Americans, none of these are convenient or even feasible options.

The other thing is that deposit interest rates will probably increase after this. Regional banks will need to incentivize depositors, so this will be a natural avenue for doing so. The increase in deposit interest rates may hurt the bottom line in the short term, but in the long run it incentivizes more deposits and shores up more trust in the banking sector. This is good for banks.

The Fed Meeting

The big question seems to be what rate hiking might look like now. One camp believes that the current crisis will cause the Fed to pivot and slow down to even pause rate hikes completely. Others believe the Fed must save face and will continue with rate hikes as originally planned. As with all rate hikes, this decision will be watched closely. Personally I think the choice matters very little for KRE. If the Fed continues to raise rates, it possibly signals a few things. First, in the Fed’s view the current issues are not a big concern, which is bullish. Second, it means that regional banks raising deposit interest rates might not actually hurt their bottom line as much if they have even higher rates to work with, which is bullish. Third, it could signal that the Fed is determined to raise rates despite the economic issues. This is bearish for the broader market but not necessarily something that changes a lot for banking. Either way, people and businesses still need banking services. And how would they (conveniently) get access to higher rates unless they deposit with a bank?

If the Fed signals that they are slowing down rate hikes or even going toward rate cuts, then this also sends some possible signals. First, it could be taken as a sign that the Fed believes there are big issues in the banking sector, hence the 180-degree pivot. In the very short term, this interpretation is bearish. However, banking insiders are still buying, and that is probably a stronger bullish signal. Second, rate cuts would be a decisive Fed pivot, which would be extremely bullish for all risk assets.

In summary, I don’t see either situation being too unfavorable for KRE. Given how far it has already fallen and given the strong fundamentals, it is at a decent entry point.

The Trade

I believe long delta, short vega on KRE options remains an attractive position. IV and option premiums remain extremely high compared to historical norms. Given the directional uncertainty in the near term, I think a short strangle (selling OTM calls and puts) to capture a bigger portion of the volatility risk premium could be worth consideration. Currently I have stuck with selling OTM puts that, if assigned, would make a satisfactory entry price.