Lower Rates Could Be A Drag On the Financial Select Sector SPDR (XLF)
Stock Option Assassin | May 15, 2014 01:59AM ET
Financial firms are a reflection of economic activity; which has been lackluster as of late. An unusually cold and snowy winter in large areas of the United States slammed output, leading advance estimates of economic growth last week to show the economy expanded at a pace of 0.1 % annual growth. The number fell short of the 1.6% forecast for the first quarter, as well as seeing a decline from a 2.6 % annual advance in the fourth quarter of last year.
On top of weak economic growth, labor market data offered mixed results. Although the headline number showed the economy added 288,000 jobs in April and the unemployment rate fell to a five-year low of 6.3%, labor market participation dropped. The labor force declined by 806,000 workers in April, the fourth-largest decline since the Department of Labor began recording the statistic in 1948.
Uncertainty surrounding the strength of both the labor market and economic growth led Federal Reserve Chairwoman, Janet Yellen, to comment that low interest rates remain the favored policy choice. When considering what this all means for financial markets, it is safe to start with iShares Barclays 20+ Year Treasury Bond (TLT ). The bond index has been trending higher since January, catching many analysts off guard, considering that the Fed is in the process of ending its stimulus program.
One cannot fight price movements however, causing investors to trade with the idea that interest rates are falling. The chart below shows that rising interest rates in 2013 led Financial Select Sector SPDR (XLF ) to trend higher for the entire year. This is due to the way banks earn profits. Banks tend to borrow using short term rates and lend to borrowers in longer time periods, profiting off of the interest rate spread between the short term and long term rate. Lower long term rates mean less profits for financial institutions.
As rates began to fall in 2014 the financial ETF began to consolidate. The financial index’s price action looks to have heavy resistance above the 22.5 level in the chart below. Due to the resistance and what looks to be a head and shoulders pattern that began to develop in January, I am looking to initiate a bearish options trade.
The trade of choice will be a bearish put spread, where I buy the 22 July put option on XLF and sell an equal number of 20 July put options. The spread will cost me around 48 cents, but could pay as much as $1.50 if the price falls below 20 by expiration. The trade offers a 3:1 risk/reward ratio, which is fairly attractive.
Considering the thesis that the economic environment remains uncertain and interest rates may stay at suppressed levels throughout the summer, this put spread could be a great way to position for a near term decline in the financial sector.
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Author Bio: Andrew Sachais’ focus is on analyzing markets with global macro-based strategies. He is a former hedge fund trader and currently writes for TheStreet.com and Motley Fool. Sachais takes into consideration global equity, commodity, currency and debt markets, and is a recent graduate of Georgetown University, where he earned a degree in economics.
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