Goldman Sachs’ Misconduct… How to Play the Banking Sector’s Latest Black Mark
by Karim Rahemtulla, Options Expert
Tuesday, April 20, 2010: Issue #1242
Down with Goldman Sachs (NYSE: GS), right?
After news broke late last week that the SEC has filed civil fraud charges against the investment bank, many onlookers have called for fury to be unleashed against Goldman and, in turn, its fellow banking behemoths.
But those calling for Goldman’s breakup are being optimistic. Goldman has about as much chance of being put out of business as Philip Morris (NYSE: PM).
That’s because, as reprehensible as Goldman’s behavior is, the U.S. financial system is a cash cow for the government, much like tobacco companies are a cash cow for the government because of the taxes that Washington attaches to tobacco products.
And you don’t kill cash cows.
As an investor, though, here’s what you can do to play this latest black mark on the banking sector…
Goldman Sachs’ Shenanagins
Let’s briefly recap how this situation arose…
Basically, the SEC has caught Goldman with its pants down, based on a huge conflict of interest in the subprime mortgage market (yes, that old nemesis again). Turns out that Goldman was playing both sides of the market. The company allegedly created a product that it knew would benefit one side over another and stood to profit from the fees for creating it.
Specifically, it issued subprime mortgage CDOs (Collateralized Debt Obligations), while also playing the market’s downside, knowing that the house would eventually cave in. Result: a massive profit.
As it stands, the SEC suit is a serious allegation… and more bad publicity for the banking sector. But this latest salvo across the bows of the financial sector is nothing short of a power grab by the government, which is struggling to push through the most radical agenda of reform since the introduction of the Glass-Steagall Act in 1933. Glass-Steagall came in the aftermath of the banking sector collapse when the government wanted to limit the activities of commercial banks to quell speculation. The Act was repealed in 1999.
Today, the government is again trying to curb what it considers speculative trading by commercial banks.
Now, you may agree that Goldman and the other big banks deserve their come-uppance, since the government bailed them all out.
But at what cost? Along with the bad comes the good. And it’s not just a few billion or hundred billion dollars of losses at stake here… but financial product innovation.
The Wrong Scapegoat for the Financial Crisis
Those who blame the financial crisis on product innovation are wrong.
The crisis was the result of greed and dishonesty on the part of the banks, realtors, appraisers, a large number of homebuyers and sellers, plus the government. All were complicit.
What didn’t cause the crisis was the market for CDOs. They’re nothing but contracts, traded and rated by debt rating agencies. Those contracts failed because those who prepared them, used them, bought them and sold them did so with mal-intent. Blaming the innovation of CDOs for the financial crisis is merely using them as a scapegoat.
It’s the innovation of financial products that allow millions of qualified homeowners, would-be car buyers and business owners, etc, to be able to buy, sell and go into business with relatively low barriers, compared to other countries.
Many parts of the world – China and India, for example – don’t have a credit verification system, or accessible mortgage industry. Instead of 10% down, buyers must buy in cash or put 50% down. Prudent, maybe. But as history has shown, it’s not the credit card that gets people in trouble, it’s the people using the card.
So what’s next for Goldman?
The Government Wants to Regulate… But it Can’t Outlaw Innovation
Given the extent of the financial crisis, the public outcry and massive costs involved to prop up the system, it’s not surprising that the government is now desperately trying to play catch-up and regulate the financial sector.
But Goldman is nothing more than a poster child for the government’s attempt to over-regulate it.
It will succeed (and the SEC suit against Goldman may actually accelerate the process), but so will Goldman. That’s because while the government might be able to write laws preventing this or that, there are no laws against financial innovation.
So at some point, I think Goldman shares might offer an excellent opportunity. It’s understandable if you don’t want to invest in such a company and there is certainly more headline risk to come, so buyers must beware. But there’s a strategy that allows you to limit your losses and enjoy unlimited upside…
The Best Way to Play Uncertainty and Volatility
A “married put” is a simple trade to execute.
You simply buy shares of the company and buy put options against them.
In this case, if you were to buy Goldman shares, buying put options against them would give you the right to sell your shares at a certain price (the strike price).
- If Goldman drops below that price, you’ll be protected from the stock’s further decline.
- If Goldman shares move higher, your loss is the amount of money you spent for the put options. And even then, the rise in the share price should more than offset that loss.
The married put strategy is perfect to use during periods of volatility and uncertainty. It gives you insurance against a collapse, while leaving your upside unhedged.
Good investing,
Karim Rahemtulla
Any investment contains risk. Please see our disclaimer.
16 Responses to “Goldman Sachs’ Misconduct… How to Play the Banking Sector’s Latest Black Mark”
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
very good comments in your article, but I do not agree that PRODUCT INOVATION WITH THE INTENT TO STEAL OR DEFAULT THE CONSUMMER OR INVESTOR IS FAIR LEGAL OR HONEST WAY TO MAKE MONEY. They new in advance the end results of these new inovations. Why should these companies and people be allowed to function in an HONEST SYSTEM
if there is one???
all this people should be prosecuted as thiefs.
It is insane that the fund manager makes $19 BILLIONS on these deals. he should be in jail along with all the Goldman directors. I am a Realtor and I never sell a property to anyone with the intention to steal their money.
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I chose a different strategy: STO GS May 150 Puts @$5.00 last Friday when GS shares tanked. I decided to take the risk that GS shares were not going to drop another $15 from Friday’s close to May options expiration. For just the cost of the option commission ($12.95), I stand to make $2,500 as long as GS remains above $150. I could BTC and already make 50% on the transaction, but at this point, I like my chances that GS stays above $150. If it starts to move south, I can always close it out and should still keep part of the $2,500 premium I have already collected.
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A married put…simply put (no pun intended) a credit default swap!!!
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What’s the difference between a married put and a regular old call of similar terms? It seems they would have the same profit profile. The married put requires a lot more capital but delivers any dividends the come along. (I’d expect anticipated dividends to be reflected in the difference between the call price and the put price.)
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Perhaps the ETF UNG (US Natural Gas) is worth investigating also.It has lost billions for mostly small investors with the share price dropping from over 60 USD to under 7 USD in less than 2 years. For me, as a small investor, it certainly seems that this security was designed to fail and wonder whether Goldman Sachs shorted this also. The disclosures do mention there are risks involved but couldn’t see anything about Contango !! Something that the organisers must surely have been aware of. It also mentions that the managers can trade for their own account and guess they took full advantage of this!!
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This is the trouble with the gambling community, er I mean investing community, you feel it is alright to make money for doing nothing and screwing someone else. People like Soros contribute nothing in the scheme of things other than fattening his own bank account. We should separate the gambling (set up “off Wall Street betting”) from true investing. Make the gamblers put up their own money for their betting.
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What’s the difference between a married put and a regular old call of similar terms? It seems they would have the same profit profile. The married put requires a lot more capital but delivers any dividends the come along. (I’d expect anticipated dividends to be reflected in the difference between the call price and the put price.)
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Amy,
When you say “a regular old call,” could you explain that a bit more? Are you referring to just a call option or covered calls? Karim is having a hard time understanding your question because of that… please explain and we will get that answer to you asap.
Thank you,
Investment U
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Hi, Investment U,
For someone who claims to be an options expert, your response is not so bright, and does not do credit for your institution.
Of course, Amy means a regular long call option. Theoretically, a regular long call option is equivalent to your “married put.”, but one wouldn’t need to mess with owning the stock, and dealing with the dividends.
On the other hand, maybe your response is indeed smart, if the hidden intent is avoid answering the question.
Please excuse my candid response. This day is not going well for me.
Take care.
JPL
4/25/2010
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I chose a different strategy: STO GS May 150 Puts @$5.00 last Friday when GS shares tanked. I decided to take the risk that GS shares were not going to drop another $15 from Friday’s close to May options expiration. For just the cost of the option commission ($12.95), I stand to make $2,500 as long as GS remains above $150. I could BTC and already make 50% on the transaction, but at this point, I like my chances that GS stays above $150. If it starts to move south, I can always close it out and should still keep part of the $2,500 premium I have already collected.
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What’s the difference between a married put and a regular old call of similar terms? It seems they would have the same profit profile. The married put requires a lot more capital but delivers any dividends the come along. (I’d expect anticipated dividends to be reflected in the difference between the call price and the put price.)
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With the married put, if GS falls or stays the same you do not profit and you lose by the premium of the put. If GS rises by less than the put premium you do not profit. Only if GS rises by more than the put premium do you profit–and this is why Amy says that the married put resembles a call. The upside of this purchase is comparable to the downside so it is not a good trade. The GS price will trade on politics, not earnings; it is unpredictable. The way to come out ahead with our knowledge about GS is to invest our money elsewhere. GS and everything about it is Poison Ivy.
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Perhaps the ETF UNG (US Natural Gas) is worth investigating also.It has lost billions for mostly small investors with the share price dropping from over 60 USD to under 7 USD in less than 2 years. For me, as a small investor, it certainly seems that this security was designed to fail and wonder whether Goldman Sachs shorted this also. The disclosures do mention there are risks involved but couldn’t see anything about Contango !! Something that the organisers must surely have been aware of. It also mentions that the managers can trade for their own account and guess they took full advantage of this!!
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instead of a married Put, unless you have significant dividends at stake, a straddle with both a put and call option would be better, with significantly less capital output. The only way to loose is if the stock goes no where before expiration, if you firmly believe the stock will move up, use the call or a leap, and protect the downside with the put. An always abide by your stops. Or wait until panic hits, and buy low, people buying City bank a year ago even though city bank had a horrible future outlook, and is still far from out of the water, have made 4x their money. (too big to fail has some advantages)
Safety and prudent investing is one thing, so dedicate that part of your portfolio to good dividend payers, but have some money to let ride on the contrarian side when things are really down.
And remember what Buffet says:
Rule #1 never loose money
Rule #2 never forget rule #1
also keep it simple, simple focused business are what Berkshire purchases / owns.
Berkshires philosophy, leave the management in place that built the business, Take a closer look before spending your money on big companies that buy successful businesses and destroy them by rolling them into a bureaucracy that makes Government look efficient (I happen to work for the latter, and the real talent who built the business is long gone and building something else, better to follow them than buy the behemoth)
Reading a bit on UNG and VIX, complicated to understand how there is a real upside to play.
Happy Investing
If you don’t understand it, don’t buy it!
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With the married put, if GS falls or stays the same you do not profit and you lose by the premium of the put. If GS rises by less than the put premium you do not profit. Only if GS rises by more than the put premium do you profit–and this is why Amy says that the married put resembles a call. The upside of this purchase is comparable to the downside so it is not a good trade. The GS price will trade on politics, not earnings; it is unpredictable. The way to come out ahead with our knowledge about GS is to invest our money elsewhere. GS and everything about it is Poison Ivy.
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A married put…simply put (no pun intended) a credit default swap!!!
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