After a tough start to the year, banks are back. So, let's consider a bull spread trade in popular exchange traded funds that move with the sector, namely the XLF ETF. Financial Select SPDR is rising nicely lately.
XLF also looks poised to make a second week in a row of stout gains.
While the 12-month Relative Strength Rating of 57 is not quite exciting, the three-month RS score of 63 on a scale of 1 to 99, according to MarketSmith, shows some improvement.
JPMorgan Chase, Bank of America and Morgan Stanley all trounced earnings estimates. On Wednesday, Goldman Sachs noted weaker Q2 results. Earnings missed the consensus estimate. Revenue came in higher than analyst estimates. Despite the mixed results, shares remained higher in Wednesday's trading.
The picture being painted of banks? Looks like one of resilience. While the sector does face some headwinds, including a huge decline in investment banking revenue, valuations are far more attractive than a lot of the market.
Therefore, investors expecting buoyancy in the sector can consider a bull put spread on XLF, which includes all of America's big banks.
XLF Today: Constructing A Bull Put Spread
To construct a bull put spread, simultaneously sell a put and buy a put at a lower strike price with the same expiration. With XLF trading near 35.15, investors can consider selling a 35 put while buying a 33 put, both with an Oct. 20 expiration.
To place the trade investors will receive a credit of 45 cents per set of option contracts, based on recent trading. This coincides with a maximum profit of $45 should XLF remain above 35 on expiration.
To figure out the maximum loss, simply take the width of the two put option strikes, minus the credit received. In this case, a maximum loss of (2-.45) x 100 = $155 per set of option contracts get realized if XLF trades below 33 on expiration.
This trade will earn a profit if XLF remains flat or trades higher on expiration. With shares of XLF currently trading sharply above the 50-day moving average and the 200-day line, the industry should have good areas of technical support moving forward.
One downside to this trade? The relatively small credit received. This is an issue as the higher cost of options trading, especially in spreads, will take a cut into investor profits.
Therefore, as a good alternative, use the same bull put spread on an investor's favorite large-cap bank.
For example, on sector leader JPMorgan investors could place a 155/150 bull put spread on the same Oct. 20 expiration for a credit of $190 and a maximum loss of $310.
With JPMorgan already reporting earnings the stock will likely trade closely in line with the sector. Due to the higher share price an investor will have to trade far fewer spreads — and therefore pay less commissions — to get the same risk tolerance.
