A Trade To Close The Year

| About: Financial Select (XLF)


The Federal Reserve is primed to re-start tightening the Federal Funds Rate.

This is expected to perk up the financial sector (which has already started to happen).

The trade setup below suggests, to go long financials and optionally to go short the S&P 500.

Everyone and their uncle now expect that the Janet & Co. will resume tightening interest rate in the next 4 months. Chances are that it won't happen in September (~20% probability) but there is very high probability (~80%) that a December hike will happen.

Given this sentiment (and I have no good reason for being a contrarian on this one), I started thinking how can one make some "beer money" out of this. If interest rates do go up, then financial stocks (particularly insurance companies and banks which depend on interest rate spreads) would benefit but the rest of the market does face some risk between now and the end of the year, though mostly because of valuation and technically the market does need some excuse to sell off, and let off some steam.

However the drop in long term interest rates, and rise in short term interest rates is flattening the yield curve, which will likely give the market some jitters. (see figure above).

What are you waiting for? Do you need me to ring a bell?

So, here is the setup: go long financials and optionally short the S&P 500. Close out the trade before December 13th (the date of the last quarterly Fed meeting of the year) following the Wall Street adage - buy the rumors and sell the news or let it expire hopefully in the money.

The suggested vehicle for my long trade is put options on the very large and liquid ETF - XLF. I suggest selling naked at the money put's (strike $25) which will net you about $1.15 per share.

Optionally, to juice your return and risk, you can go short the S&P 500 by buying at the money put's on SPY. Use the premiums you obtain from selling XLF puts to buy SPY puts, so the trade does not require any cash (you will need a margin account though).

In fact Barron's columnist Stephen Sears has suggested a similar trade in his column "The Striking Price" recently where he suggests buying BAC calls.

I think my suggested trade is more conservative as it deals with an ETF rather than a single stock, however returns may be less than the BAC trade suggested by Barron's. The risk is of course the trade does not work and you will be put the XLF shares at $25, which you can sell at loss. Given the breadth and liquidity of XLF and the short term nature of the trade, short of a meteor strike on the planet, downside risk is fairly limited, as long as the size of your trade is consistent with the objective of earning beer money.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XLF over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.