How to Generate Explosive Returns in the Financial Sector

High Volatility, Options, Payments Industry

After the February 5th market meltdown, there hasn’t been any real consensus on what’s next for the financial markets. There are some who think stocks are in store for another correction. Others think this is the start of yet another huge rally.

Regarding volatility, opinions are also mixed. Is the spike in the VIX a prelude to more volatile times ahead? Or, are we just going to go right back to a period where shorting volatility is the easiest way to make money? Once again, it’s far from clear what the crowd thinks on this matter.

On the other hand, there is one point pretty much everyone in investments agrees on – interest rates are going higher. At the March FOMC meeting, we’re almost certainly going to see a quarter point hike in the Fed Funds Rate. (The market says the odds of a 25 basis point rate hike are about 90%.)

Okay, so rates are going higher – and could continue seeing regular hikes for the foreseeable future. So how do we make money off these expected events?

The sector that stands to profit most from higher interest rates is the financial sector. Banks and other financial companies generally increase profits across the board when interest rates go up. And, higher profits should mean higher stock prices to follow.

There’s certainly some big money betting on a large surge in financial sector stocks. In fact, a trade this week in the Financial Select Sector SPDR ETF (NYSE: XLF) is about as bullish as it gets.

This trade, called a risk reversal, involves selling puts to finance long calls. If XLF goes up, there is unlimited gain potential. However, there’s also nearly equal risk on the downside (except XLF can’t go to zero of course).

More specifically, the trader sold the June XLF 27 puts for $0.36 and purchased the June 31 calls for $0.41 (with the stock price around $29.50). Therefore, the trader paid a total of $0.05 for the risk reversal, which was executed 41,000 times. The cost was about $200,000 for the trade, and it will make about $4 million for every dollar XLF climbs above $31 (and lose the same amount below $27).

Clearly, you can see why this is such a bullish trade. It’s also risky, so I don’t recommend it. Instead, you can make a very similar trade by turning the naked put into a short put spread.

For example, in place of selling the 27 put by itself, you sell the 24-27 put spread (selling the 27 put, buying the 24 put) for $0.24. It would increase your cost on the 31 calls to $0.17, but it would cap your downside risk to about $3.00. You’d still be able to participate in the vast majority of the upside potential if XLF does go up as expected.

Sometimes a simple tweak to a strategy is all it takes to define (and substantially reduce) risk. With XLF options so cheap, you can easily participate in this bullish trade with a fraction of the risk of the original trade.

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