New Trade – $XLF: Take it to the Banks

by Dan October 6, 2015 1:41 pm • Commentary

Next week is a big one for banks stocks as about a third of the weight of the Financial Select etf (XLF) are set to report Q3 earnings:

Oct 13th: JPM

Oct 14th: BAC &, WFC

Oct 15th: C, GS & USB

All of these stocks are significantly off of their recent 52 week and multi year highs, and all are down on the year.  Banks stocks were widely perceived to be the early beneficiaries of the Fed’s supposed plan to raise interest rates for the first time in 9 years.  But with the FOMC’s statement at their Sept meeting, and the subsequent weak economic data in the U.S.. rate increases are likely off of the table for 2015.   We think the relative weakness of large money center banks that make up some of the largest holdings in etfs like the XLF make it particularly vulnerable in the near term. A re-test and break of the recent lows could be in play if we get a spell of weak results and guidance.  

The recent recent volatility in banks stocks had the XLF do something it hadn’t done since its lows in 2011 during the European Sovereign Debt crisis, and that’s break the uptrend:

[caption id="attachment_57442" align="aligncenter" width="600"]XLF 5 yr chart from Bloomberg XLF 5 yr chart from Bloomberg[/caption]

Options prices have come in meaningfully since the late August volatility spike, but remain considerably elevated compared to the low teens beforehand:

[caption id="attachment_57443" align="aligncenter" width="600"]XLF 1yr chart of 30 day at the money IV from Bloomberg XLF 1yr chart of 30 day at the money IV from Bloomberg[/caption]

XLF options, despite being expensive in volatility terms look dollar cheap.

So what’s the trade?  

We think Q3 earnings are going to be weak, and given the uncertainty about rates hikes think forward guidance could be as well. We want to use last week’s strength as a good entry to play for a re-test of the recent lows in the XLF. Here’s our trade:

Trade:  XLF ($23.10) Bought Oct16th  23 put for .25

Break-Even on Oct Expiration (8 trading days):

Profits: below 22.75, down 1.5% from current levels.

Losses: up to .25 between 22.75 and 23, with max loss of .25 above 23

Rationale: risking 1% of the underlying etf price to break-even down 1.5% with what earnings catalysts. This is something we probably won’t spread unless selling occurred into the bulk of the earnings events. Ideally we’d be able to simply trade out of the put with the etf lower on those earnings.