Financial ETF XLF: A Call Spread Option with Excellent Risk Reward

While the major indexes such as the Dow (DIA), the S&P (SPY), and the NASDAQ (QQQQ) are showing performance close to double digits, the financial have turned into the dogs of the market. The XLF (XLF), which is an ETF that incorporates the largest banks in the US, has lagged behind the major indices.

The banking sector is still feeling the hangover from the financial credit crises, and companies such as Goldman Sachs (GS) and Bank of America (BAC) are still looked at with an evil eye. In fact, according to a story in the Wall Street Journal, Goldman is being sued again for a second CDO, where they did not offer information that was pertinent to investors.

Upside Potential

In a recent filing with the SEC, J.P. Morgan (JPM) reported that trading during the first nine months of 2010, was excellent and there was an instance where the bank experienced only eight days of trading losses, all of which were in the second quarter. During the quarter, ending September 30, 2010 the bank made money every day from trading.

Bank of America reported a perfect trading quarter, in the first period. In addition to no losses, it had 16 days of trading gains over $125 million.

J.P. Morgan reported 12 days where it brought in more than $200 million on each day, while Bank of America had at least 25 days where it made more than $100 million from trading in the third quarter.

Market Action

The XLF has chopped around in a tight range during the last 12 month. Recently, the FOMC released a statement saying that they are considering allowing some banks to increase their dividends. This news has created a bid in the banking sector, which has potential for further upside.

A lot of the smart money in the options pits is moving into the larger banking groups to take advantage of their trading revenues and a sector that has lagged behind.

On November 9, 2010 Citigroup (C) and Bank of America where in the top four options volume leaders, with nearly 70% of the volume moving into calls. Calls are the right, but not the obligation to purchase a security at a specific price, on a specific date.

Options volume on the XLF has been skewed to the calls during the past five trading days, which means many investors, are looking for further upside in the banking sector.

The measurement of the relative cost of options is reflected in implied volatility. This is the markets view of how much a security will move during a year on an annualize basis. The number is displayed as a percent. Currently the implied volatility of the XLF is 25.2%. Options on the XLF are therefore relatively cheap given the range in volatility over the past 12 months. The range has been 51%-23%. A high-implied volatility would make options expensive, where a low implied volatility makes them cheap.

A trade that makes sense that would take advantage of the potential upside in the XLF is a January 15-17 call spread. A call spread is a trade in which you buy (or sell) a call with a lower strike and sell (or buy) a second call with a higher strike price. This trade expires on January 22nd, and should take advantage to a rally into the end of the year. The cost of the call spread is 65 cents, with a maximum gain of $2 ($17-$15). The reward to risk profile is 3 to 1, which is very robust. If the market fails to move higher, the loss is capped at the premium paid for the call spread which is 65 cents ( for 1 contract which is 100 shares, the loss is $65). The maximum upside for the trade is $2 (for 1 contract which is 100 shares, the profit is $200).

David Becker is the founder of Binary Options School.

Disclosure: Position in XLF.