Banks’ Recovery Rally Could Make Traders 186% Profits

The Financial Select Sector SPDR (NYSE: XLF) offers a diversified way to invest in the banking sector.

The banks reported record profits of $40.3 billion in the first quarter of 2013, and sales and trading revenue exceeded expectations in Q2. Yet, while the broader market has made up all of the losses suffered during the financial crisis, XLF remains below the halfway mark of the precipitous drop from the 2007 highs to the 2009 lows. A retracement to the midpoint of that decline gives us an objective of $22, about 8% above current levels. 

The sideways price action in 2012 between $14 and $16 targeted $18 on an upside breakout. The $18 level was exceeded in March, and now acts as important technical support. It is also the midpoint of the 52-week price action from roughly $15 to $21.

To derive an ultimate breakout target, traders can look to the longer-term trading range on the chart below between $10 and $18. The $8 height of this range gives us an upside target of $26.

XLF Chart

The $26 target is about 27% higher than current prices, but traders who use a capital-preserving, stock substitution strategy could almost triple their money on a move to that level.

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One major advantage of using long call options rather than buying a stock outright is putting up much less capital to control 100 shares — that’s the power of leverage. But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.

Simply put, you want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:

Rule One: Choose an option with a delta of 70 or above.

An option’s strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.) 

It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. In-the-money options are more expensive, but they’re worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.

The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option’s delta using an options calculator, such as the one offered by the CBOE

With XLF trading at about $20.36 at the time of this writing, an in-the-money $18 strike call option currently has $2.36 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option currently has a delta of about 81.

Rule Two: Buy more time until expiration than you may need — at least three to six months — for the trade to develop.

Time is an investor’s greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.

With these rules in mind, I would recommend the XLF March 2014 18 Calls at $2.80 or less.

XLF Call Options

A close below $18 in XLF on a weekly basis or the loss of half of the option’s premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $280 or less paid per option contract. The upside, on the other hand, is unlimited. And the March options give the bull trend more than seven months to develop.

This trade breaks even at $20.80 ($18 strike plus $2.80 options premium). That is less than $0.50 above XLF’s current price. If shares hit the $26 target, then the call options would have $8 of intrinsic value and deliver a gain of more than 180%.

Recommended Trade Setup:

— Buy XLF March 2014 18 Calls at $2.80 or less
— Set stop-loss at $1.40
— Set initial price target at $8 for a potential 186% gain in seven months

For more analysis on XLF, see the video below: