Barcap recommends options play ahead of stress test results

In its latest European Credit Alpha research, published today, Barclays Capital recommends options strategies for investors to hedge against the possibility of negative bank stress test results.

In the first recommendation, investors could take advantage of the payer skew in iTraxx options by buying a €100 million notional payer on Europe series 13’s September expiry at a strike of 120bp (index ref 113bp), with the premium 60bp. Against this Barcap advises selling a similar amount of notional payers for the same expiry at strikes of 130bp and 160bp for premiums of 43bp and 19bp respectively.

This trade makes money from spread levels of 120bp to 170bp, beyond which it begins to lose money. Barcap view spreads beyond 170bp over the next two months as an extreme tail event. However, investors comfortable with this risk can put on this trade and gain on more modest widening scenarios. The maximum payoff on this trade occurs if the index is between 130bp and 160bp.

The second recommendation is to make use of the correlation between iTraxx and Euro Stoxx 50 by selling a €100 million notional payer on the Europe September expiry at a strike of 145bp, premium 29bp, at an income of €290,000. By then buying 322 put contracts on Euro Stoxx 50, at a September expiry strike of 2600 (ref 2710) and €90 premium, the €290,000 cost leaves the overall trade costless.

If the market retraces last month’s rally, this trade will likely head into positive territory. Meanwhile, if credit and equities rally or experience a limited negative move, the trade will likely expire with zero P&L. The downside risk for this trade would be if credit widens significantly with no, or a limited fall in equity values, a scenario that Barcap considers unlikely.