Options Update: Banking on a Bounce in the Select Sector SPDR Financial Fund?

• July 23, 2008
• Mark Fightmaster

Banking on a Turnaround?

We’re having a bit of a delay in receiving the data that I use to pull our Options Update subject, so I sauntered over to my handy-dandy computer desktop and looked around for data from another source. Well, I definitely found activity that caught my eye. So let’s take a look, shall we?

I looked into the most-active calls on the 6 markets and noticed quite a bit of activity on the Select Sector SPDR Financial Sector
. The activity was dispersed through several contracts, but the most popular seems to have been the August 21 call (XLF HU) and the August 23 call (XLF HW). With the exchange-traded fund (ETF) trading in the 22 region, this strike is also popular, just not in as much demand as the 21 and 23 strikes. There is the occasional September series contract, but most were in the August series. Another contract that stood out was the January 2009 23 call (XLF AW) – a rather long-term play.

What does all of this activity mean? There are various scenarios, but for the purpose of this article, let’s assume that the activity is the opening of new contracts. If this is the case, the activity is bullish in nature, as the hypothetical purchaser has entered long positions. The money will be made when shares of the ETF advance past the premium paid for the contract added to the strike price.

If this is truly the scenario, one would think that a majority of option players are betting that the XLF is in the process of a turnaround. The problem with a turnaround is that you don’t know it has happened until it is in your rearview mirror.

Brokerages and Option Players Buy the Idea

Let’s look first at how analysts feel about the financial sector. Although it seems that you can’t direct your Internet browser to a financial news site without being bombarded by bad news from a bank, analysts are actually a lot less pessimistic than I originally thought. Looking at the percentage of “buy,” “hold,” and “sell” rankings for components of the financial sector shows that only 9% issue “sell” recommendations. The remaining 81% is split pretty evenly between the “buy” and “hold” camps. Yes, the “hold” rankings could be upgraded to “buys,” but there is a nearly equal chance for downgrades. With 81% of the brokerages following the sector ranking the components a “hold” or better there is a good chance for momentum-killing downgrades.

Option players are a bit more vociferous in their support of the XLF. The Schaeffer’s put/call open interest ratio (SOIR) for the ETF checks in at 0.89, in the 18th percentile. This percentile ranking suggests that there isn’t a great deal of money waiting on the sidelines to push the ETF higher as optimism appears to b running high.

Making Money?

During the past 4 weeks, shares of the financial tracker have rebounded, gaining 3.5%. That may not seem like a lot, but positive price action is positive price action – and it is welcomed by those that harbor bullish feelings on XLF. However, is this the beginning of the end of the sector’s troubles? I’m not saying it is out of the question, but it may be difficult.

Yes, it seems that the stock may have formed a double-bottom at the 18 level. If that is the case, the road higher is fraught with peril – mainly in the form of trendlines. The ETF has shied away from overhead resistance levied by its 10-month moving average since May 2007, that’s the bad news. The good news (for the bulls) is that there is some room to run higher before hitting this trendline. This means that the ETF could advance into the upper reaches of the 26 region before staging a retreat.

Of course, betting on a run up to resistance at the 10-month trendline does not take XLF’s 20-week moving average into account. This trendline is perched right at the 24 level, and has provided rather stoic resistance throughout the past year plus. This moving average could make a run any higher rather difficult.

The Verdict? Again, we will not know if this is rebound is sustainable until we look at this period in retrospect. Is there reason to be bearish on financials? The answer is a resounding yes. There is too much optimism toward a struggling sector/ETF, making this a near-textbook definition for a bearish contrarian play. Does this mean that there aren’t opportunities to profit on solid performers in the sector? No, and this is where you have to do the footwork. Make sure to check out the various tools and screeners available to you on our site if you would like to find a bullish play in the financial sector.

If you have any questions or comments, make sure to email me. I will do my best to answer your question or address your concern.

Want more of my thoughts on the market? Don’t like my views and want to see those of my colleagues Andrea, Elizabeth, Jocelynn, Colleen, or Joe? Make sure to check out our Schaeffer’s Daily Market Blog section throughout the trading day.

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