This ETF Used As Bank Earnings Hedge

While sturdy quarter expected, some investors are using XLF to hedge against surprises.

Reviewed by: Saqib Iqbal Ahmed
Edited by: Saqib Iqbal Ahmed

New York (Reuters) – The financial sector is expected to be a bright spot for U.S. earnings growth in the third quarter, but options traders are playing it safe by snapping up protection against any surprises.

Market volatility tends to rise during earnings season, and with several heavyweights reporting next week, investors are trying to hedge their bets by adding to protective positions in the options on a key ETF that tracks the financials.

Bank of America Corp, JPMorgan Chase & Co. and Goldman Sachs Group are due to report their results.

Analysts expect the financials sector of the benchmark S&P 500 index to report quarterly earnings growth of 8.5 percent, the third-best of all the S&P sectors, according to Thomson Reuters data.

Financials Underperforming

Still, the S&P 500 financials sector has underperformed the broader market.

While activity in individual banks' options has been mixed, traders in the Financial Select Sector SPDR Fund (XLF | A-87) appear to be guarding against further declines. Here’s how XLF has performed against the broad market as measured by the SPDR S&P 500 (SPY | A-99):

Chart courtesy of

"People are using the ETF to help them control their risk exposure," said Scott Fullman, chief strategist at Revere Securities Corp. “Ahead of the earnings, ahead of disclosures that may be coming about, you have a lot of people just looking to be hedged."

Put Options On XLF Rise

Traders have been showing a preference for put options on the XLF, with an increasing level of put-buying since mid-September. That was when the U.S. Federal Reserve postponed a highly anticipated interest-rate increase, which would have been the first such move in nearly a decade, on worries that sluggish global growth may hurt the U.S. economy and companies.

Open interest in puts, conveying the right to sell the shares at a set price in the future, has jumped 13.5 percent compared with a 16 percent drop in open interest in call options.

Currently, there are 1.28 put contracts active for each open-call contracts, up from 0.95 on Sept. 17, according to data from options analytics firm Trade Alert.

Recent negative news from big European banks—such as a 6 billion euro ($6.78 billion) pretax loss and a possible dividend cut at Deutsche Bank, along with Credit Suisse's plans to tap investors for a "substantial" capital raise—could also be adding to investors' concerns, Fullman says.

Low Volatility On XLF

Cantor Fitzgerald analysts noted recently that volatility in this ETF has been low, therefore offering an opportunity for investors looking to hedge against volatile bank results.

“We continue to believe that global regulation, the opacity of balance sheets, a flatter yield curve, and lower economic activity will weigh heavily on multinational and money center banks," wrote Peter Cecchini, chief market strategist at Cantor Fitzgerald, in a comment Friday. “At $24 in the XLF, we’d be looking to aggressively hedge out bank exposures."

The fund was trading at $23.32 Friday.

Investors have been pulling money from the XLF. Since Sept. 17, the fund has seen outflows of more than $650 million, largest among the nine S&P sector ETFs.

Options prices on Bank of America, JPMorgan Chase, Citigroup, Morgan Stanley, Goldman Sachs and Wells Fargo & Co. point to expectations for greater-than-usual post-earnings stock price moves.

Steep Yield Curve Needed

Investors' outlook for the sector may be colored less by upcoming earnings and more by disappointment relating to the Fed not lifting rates in September, says Nicholas Colas, chief market strategist at Convergex in New York.

"Investors are looking for a steeper yield curve. They were looking for the Fed to lift off. They were looking for the long end of the curve to sell off and yields to go higher," he said.

Banks typically borrow short term and lend longer term, and benefit from a steeper yield curve, which allows them to borrow on lower short-term rates and lend on higher long-term rates.