The upcoming Greek bank stress test results could produce large gains or large losses for investors. However, investors can protect their holdings for a relatively small cost by hedging their investment through a fairly common method.
For U.S. investors, the only Greek bank easy to hedge with this method is National Bank of Greece (NYSE:NBG).
Potential gains and losses
The stress test results are introducing a lot of fear into the Greek banking market, causing less speculative investors to hold back from investing in this industry. However, if the results show a minimal need for additional capital at National Bank of Greece, a major piece of uncertainty would be cleared up, and new buyers could easily drive the stock higher.
On the other hand, a large need for additional capital could hammer the bank's shares as it did last year. A plunge following a recapitalization is a fairly common occurrence in the banking industry. A similar situation played out at Bank of Ireland (NYSE:IREBY) when that bank diluted shareholders to receive billions in recapitalization funds. Although Bank of Ireland shares have recovered off their lows, they are still well below pre-recapitalization levels. Investors should consider a large recapitalization a major negative for National Bank of Greece shares.
Despite the extreme amount of volatility the Greek bank stress tests are likely to produce, hedging an investment in National Bank of Greece through put options is actually fairly inexpensive.
The results of the stress tests could be available as soon as the end of this month but near-term options remain attractively priced. The March 2014 options as a near-term hedge could be good for a balance between time premium while allowing for some time in a delay of the stress test results release.
For March 2014, the last ask on a $5 put was $0.42, and the last ask on a $4 put was $0.11. While this may seem like a large amount to pay for such a short term of hedging, keep in mind the large potential swing in National Bank of Greece shares on the stress test results.
Other banks, and National Bank of Greece, in the past have lost over half their value shortly after the release of negative stress test results. If NBG does require billions in additional capital, share dilution could be very large, possibly causing a loss of this magnitude. From Friday's close, a 50% drop would mean a share price below $2.50 per share, making the put options a very successful hedge.
Looking at the situation from the other direction, the put option hedge does not cap your upside. Positive stress test results could bring many new buyers to National Bank of Greece shares, pushing shares significantly higher as a large piece of uncertainty is lifted. Shares were recently above the $6 level and stand a good chance at regaining this level if the stress test results remove the near-term threat of dilution.
A spike could carry shares even higher, possibly near $7 since National Bank of Greece would be shown to be in better shape than it was at the time shares traded above $6 each.
A good hedge
While this National Bank of Greece hedge may seem expensive at first glance, the $5 put costs less than 10% of the current stock price. If we subtract the amount that the $5 put is currently in the money from the price of the put option, it amounts to only 6.5% of the current share price. For those looking to hedge for a lower cost, the $4 put is only 2.2% of the current stock price.
For a stock that has a good chance of moving 20% or more in either direction in the near term, National Bank of Greece put options are among the best hedges available on the market. The combination allows investors to effectively insure their investment near current levels for a minimal cost while retaining the full upside of the stock.
Investors should note that since the stress test results are not guaranteed to be released by the end of the month, the results could be delayed. If they are delayed beyond March, those still wanting to utilize this hedging strategy will need to rotate into the next set of put options. This would mean an additional cost but if these options are priced like the March 2014 options, they should still be viewed as a good hedge.
An alternative National Bank of Greece investment
For those bullish on the long-term prospects of National Bank of Greece but looking to avoid the common stock for risks associated with dilution, National Bank of Greece Preferred Stock (NYSE:NBG-A) could be a good investment. Trading at around 60% of liquidation value, National Bank of Greece preferred stock has potential for upside if the bank regains stability. The dividend is currently suspended and non-cumulative, but if reinstated after National Bank of Greece regains its footing, it would yield nearly 15% based on the current trading price. The preferred stock is also far less likely to take a hit during a recapitalization as it avoids the problems associated with common stock dilution.
Hedging the results
Good investing is about balancing risk and potential reward. In the case of National Bank of Greece, both the risk and potential reward are extremely high as the market awaits the stress test results. But for a cost of 10% or less of the current stock price, investors can hedge a major move in NBG shares through put options, limiting their downside without capping their upside.
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Alexander MacLennan owns shares of Bank of Ireland (Irish-listed). He also has the following options: long January 2015 $7 calls on National Bank of Greece, long March 2014 $4 puts on National Bank of Greece, long March $5 puts on National Bank of Greece, long National Bank of Greece warrants (Athens-listed). This article is not an endorsement to buy or sell any security and does not constitute professional investment advice. Always do your own due diligence before buying or selling any security. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days.