If you believe the Fed is set to raise rates soon, Goldman Sachs has an interesting idea for how you can profit.
An increase in the federal funds rate is often considered something that would be bearish for stocks — and indeed, the market's sharp drop on Friday was apparently due to rising expectations that the Fed could hike at its September meeting. But as Goldman's options research team points out, "A rise in rates is not a negative for all equities."
Financial stocks are particularly set to be helped by an increase in short-term rates, given that many companies in the sector invest in liquid low-risk investments; as short-term rates rise, the cash on banks' balance sheets yields more. Particular names that would be aided include Bank of America, Regions Financial and Zions Bankcorp, according to Goldman.
Interestingly, the options market does not appear to be giving these companies credit for a potential rise in rates. That's where the opportunity comes in.
The Goldman research team, led by Katherine Fogertey, suggests that investors buy long-term bullish call options on financial names. These bullish derivatives, which technically represent the right to buy a stock at a given price within a given time frame, "underprice the potential for shares to trade higher in light of our analyst's fundamental views on rate sensitivity," they opine.
Stacey Gilbert, head of derivative strategy at Susquehanna, agrees that "I don't think these volatilities are pricing in these outlier Fed surprises."
However, she says that buying short-term options on some of these stocks is a better way to go.
"I think where options are best utilized is around an event where you disagree with what the market is saying," Gilbert said.
In this case, that would mean that a trader who thinks there is a greater chance of the Fed raising in September than the sub-20 percent currently assigned by the market should simply buy a soon-to-expire call in that bank in order to leverage that difference of opinion.
The Fed's decision is set to be unveiled on Sep. 21, at the conclusion of the Federal Open Market Committee's two-day meeting.