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Rebecca Engmann Darst contributed to this report. 

Financial Select Sector SPDR (XLF) – Smoke signals about the state of credit in the broader financials  – in the form of a Goldman Sachs warning on AIG (NYSE:AIG), a JP Morgan warning on Lehman (LEH), and predictions by an ex-IMF chief economist of another “whopping” bank failure in the next few months  – sent bank and brokerage shares broadly lower, adding to yesterday’s swoon on concerns about GSCE solvency. It’s at a 3% decline that we find shares in the Financial Select Sector SPDR, and with twice as many puts trading as calls, the defensive tone to trading is prima facie. Early market action has shown traders favoring long September put spreads at not just the 18/20 but also the 14/18 strikes, the latter combination costing about 37 cents and implying a possible break below the 52-week low of $16.80. The tendency to hunker down in long put positions was clear from activity at the October 22 put line, where the current $2.75 premium carries with it a break-even at current share price levels (so that further declines are necessary to generate profit for the buyer), at the 20 put line in the December  and January contracts. The fact that these are large-volume block trades speaks to the conviction with which traders are positioning defensively in financials – and indicates that it’s well-capitalized individuals or institutions seeking the positions.

Regional Bank Holders Trust (NYSEARCA:RKH) – The unsentimentally bearish mood toward the financials carried over into the Regional Bank HOLDRs Trust, where shares dropped 3.7% to $96.10 and option volume rose to 4 times the normal level. A large 15,000 chunk of volume traded at the November 125 call line at $1.25/1.30 per contract, which may or may not be closing purchases of calls shorted back on July 31, the last date for which heavy volume in this contract was registered. There’s certainly little support in the popular consensus for a recovery past those levels by mid-November (current premiums put the odds at 12%).

Energy Select Sector ETF (XLE)  – Crude oil for October delivery is trading slightly higher at present dispatch, bringing shares in the Energy Select Sector ETF up 3% to $72.06. But there’s still a sizable contingent of traders looking for the fund to probe downside in the coming weeks. Earlier today it appeared that a 43,000-lot put spread was entered in the front month between strikes 64 and 70. Both ends of the spread were credited to the middle of the market, so our analysis of the order flow is based strictly on the premiums paid, but we surmise that this was a long put spread put on for a $1.85 debit, which would require a decline in the energy ETF of 3% below current levels, not to exceed $64 – which would keep the fund’s 52-week low intact.  

Diamonds Trust (DIA)  – Dow Diamonds turned Dow Defensive today, with shares in the Diamonds Trust down 1.5% to $113.17. Option traders appear to be looking for yet more bloodletting out of the Dow-indexed fund, as puts are outpacing calls by a factor of 1.4 on a volume just south of 60,000. Much of this put activity earlier today was centered in the front month at strikes 111 and higher – notable activity includes a long put spread at the 111/116 strikes in September, which a trader entered for a $2.13 debit, looking for downside movement from current levels to as low as the 111 line.  

Capital One Financial (COF) – Out-of-the-money put spread activity in credit card and auto loan servicer Capital One Financial Corp shows option traders looking for declines above and beyond the 4% drop to $40.08 that the share price has sustained today. A trader entered a long put spread at the 25/35 lines for a debit of $2.90 that would require a decline of at least 20% below current levels to break even. This would further deepen the decline that Capital One shares have weathered over the past 52 weeks, shorn of 41% of their value during that time. Since the first of the year, as the decline has continued to take hold, accumulated put positions have outnumbered those of calls by nearly 2-to-1. Capital One’s next earnings report is due out on October 17, which could explain the positioning.

Taser International (TASR) – “More lethal” volatility hit shares of “less lethal” weapons maker Taser International this morning. Shares in the maker of the eponymous stun-gun rose 10% to $6.55 this morning as rumors circulated of a possible GE (NYSE:GE) buyout. The rumors also drove implied volatility on all Taser options higher by nearly one-third as traders rushed to buy September 7.50 calls on volume exceeding open interest. Fresh activity at the same strike in October traded to buyers and sellers. Today’s pop higher notwithstanding, Taser shares have been zapped of nearly 55% of their value so far this year, and while short interest in the stock has declined some 26% from the highs of mid-February, it’s still comparably high at 26% of the float.

GeoEye Inc (GEOY) – Shares in GeoEye Inc., the maker of high-res satellite imagery products, lost 1.2% today to read $23.67 ahead of the noon hour. What’s eye-catching about GeoEye’s option activity is the huge disparity between its implied and historical volatility readings. Since June 23, implied volatility (which reflects the option market’s anticipation for future share price swings) has shown a steady upward divergence away from the historic reading (which reflects how much shares have actually deviated). As a result, the current reading of 106% weighs in at nearly twice the historic reading. This dissonance between implied and historic volatility tends to enliven option premiums, making them more expensive to buy and more rewarding to sell. It looks here like a trader played on this relationship by selling a September call spread at the 17.50/22.50 lines for $3.50. Bear in mind here is that the spread generates the maximum profit for the trader if GeoEye shares drop below 22.50 – a strike that’s still currently in the money.  The activity here pushed overall option trading volume to nearly 3 times the normal level.      

Source: Tuesday Options Update: XLF, RKH, XLE, DIA, COF, TASR, GEOY