HSBC is the world’s second largest bank. It is an essential cog in global trade providing a large volume of currency and hedging services, a low risk and profitable business. The share price took a hit with the 2008 global financial crisis and has been slow to recover as the bank has restructured to shed unprofitable lines of business and raise capital to the stricter Basel III requirements. Prior to the crisis, it traded for over twice the current valuation. I think now that the capital goals are met and the restructuring is complete, we will see a slow and steady rise in share price. The current price is dirt cheap for a bank (selling for less than book) despite internal target return on capital of 12 to 15 percent.
This is a perfect scenario for using Diagonal Calls. A Diagonal Call lets a raptor generate a tasty income stream while still participating in upside capital appreciation. And it all happens while committing about one third the amount of capital of buying shares outright. This is a powerful one-two punch of safety and yield. I’ll demonstrate.
I didn’t pull this trade today as planned because the market was closed in honor of MLK (tomorrow!) For demonstration purposes, I’ll use Friday’s closing prices. HSBC closed at 45.24, meaning a raptor would need to risk $4,524 in precious capital for each covered call it wanted to write. If we go with the diagonal strategy however, we will commit a mere $1,529 (33.8%). Clearly, this is less risky. Action number one to take – buy the 20JAN2017 30 strike call (HSBC170120C00030000) for 15.29 a share.
You now have the right to buy HSBC for an additional 3,000 at any time between now and expiration. Note that by going deep into the money, we eliminated most of the time value on the option as the intrinsic value is 15.24. Only 4 cents is a wasting asset, which we will more than recover in the first month of our diagonal strategy. The next part of the diagonal strategy is to write a series of out of the money calls for income. This is similar to the buy-write strategy revealed in a previous post except instead of owning the shares, we hedge our short position with a long call. If we get called away, we can repurchase the shares at market and sell the long call to recover the losses (except for the 4 cents in time value). We hope to see the call expire worthless each month and roll “up and out” to a higher strike at a later date, collecting a few dollars of income each time while our long call grows in value as the underlying stock appreciates.
Action number two to take – sell the 20FEB2015 48 strike call (HSBC150220C00036000) for 0.15 a share. Let’s take a look at returns. Fifteen cents out of 15.29 capital at risk is about 0.98% over 32 days or 11.19% annualized. This beats the buy and hold yield of only 4.40% on dividends handily. And it still lets you participate in most or all of the capital appreciation upside on a company that is project 12-15% return on equity in the coming years. That is a realistic chance at a 26% annual return until the third Friday in 2017. A raptor can grow mightily fat at that rate.
A note about written calls that go just a few cents in the money: it is probably worth your while in this scenario to buy your call back at a small loss and roll forward “up and out” to the next expiry. You will put a few dollars more in the trade but you can realistically expect to pick it back up at the expiry of the long call. You thus gain a short term tax loss in the current year in exchange for a deferred long term gain. Very tax efficient.
Devour your prey, raptors!