The Force Is With Financials

Options traders are betting the upward momentum in financial stocks continues. Building strategies around the XLF ETF.

In the options market, where the smart crowd routinely reveals its expectations for stocks, it has paid, of late, to make friends with momentum.

“One of the market’s most outstanding qualities over the past few months has simply been momentum,” Sentiment Trader’s Jason Goepfert wrote in a recent note. “It has thrown off”—that is, negated the impact of—”bad news, extreme sentiment, bad breadth and negative divergences.”

Momentum has swept financial stocks, in particular, higher in recent months. Even though analysts are lowering earnings estimates on Goldman Sachs (GS) and Morgan Stanley (MS)—which could bode poorly for other financial shares, as revisions tend to roll downhill—interest in the sector remains robust.

Investors have been buying financial stocks and bullish calls on the sector in bulk, in the expectation financials will shine in 2011 after selling off for several years due to the misdeeds of certain bad actors who nearly destroyed the global financial system. “Size” buyers have been active in the Select Sector Financial SPDR (XLF), the exchange-traded fund used as an industry proxy, in anticipation of the ETF’s 81 component stocks increasing sharply in the first few months of 2011.

IN A TRADE STILL VIEWED AS a benchmark, one investor bought 250,000 March $17 calls just before Christmas, when the XLF traded at about 15. The investor’s identity is unknown, and arguably irrelevant; the trade’s huge size says it all. This investment will yield a positive return if the sector gains 13.3% in the next three months. On Friday this trade inspired imitators, as it appears big investors increasingly are betting the XLF rises to 17 in the first quarter. One investor bought 50,000 XLF March $17 calls for 29 cents, when the XLF was trading at 15.94.

Despite the sudden interest in the XLF March $17 calls, it is the third-most widely held of all XLF contracts, trailing the in-the-money January $15 calls and the January $16 calls. The expectation among options traders is that the XLF will advance steadily for the next three months.

The action is similarly bullish in out-of-the-money calls on the XLF’s major components, including JPMorgan Chase (JPM) and Wells Fargo (WFC), the ETF’s two largest stocks. Other bull plays are occurring in Bank of America (BAC) and Goldman Sachs. Citigroup (C) is trading mixed, amid some big sales of January $5 calls and the purchase of January $4 puts, but trader talk is bullish.

Although the XLF call buyer’s expectations are extremely robust, the anticipated double-digit gains they have in mind might not be unrealistic. Already, the options market is pricing major banks, including Bank of America and JPMorgan, as if their dividends will more than double in the first quarter. An increase in dividends most likely will attract new buyers and cause the stocks’ prices to advance.

THE PRIMARY DANGER WITH momentum trading is that bullish momentum eventually wears itself out, as self-reinforcing investor expectations rise to unreasonable levels. This may be why one investor with a seemingly sizable stake in the financial sector bought 30,000 XLF March $15 puts on Wednesday for 39 cents, when XLF was trading at $15.98. To lower the cost of the put purchase, the same investor sold 30,000 March $13 puts, collecting nine cents for each contract.

Yet many stock strategists have told clients that financials—along with the shares of energy- and technology-related companies—will be the best bets for the new year. This has sparked a lot of excitement, especially as the Federal Reserve’s next bout of quantitative easing is viewed as helping banks. 

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Source:  Barron’s

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