Options traders are paying the least in more than two years to hedge against declines in U.S. financial shares, reassured by analysts who say they will report the biggest profit since 2007 this year.
Puts protecting against a 10 percent decline in the Financial Select Sector SPDR Fund cost 4.12 points more than calls betting on a 10 percent increase, according to three-month options data compiled by Bloomberg. That's the lowest since November 2010. Banks and brokerages in the Standard & Poor's 500 index rallied 20 percent this year.
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The recovering U.S. economy spurred by a third round of Federal Reserve stimulus and the improving housing market are helping the stocks. Almost 79 percent of S&P 500 financial firms have posted profit that beat projections this quarter, and analysts estimate the companies' earnings will rise 8.4 percent in 2013, data compiled by Bloomberg show.
"We have a huge housing recovery, and there's still room to run," Leo Kelly, a Baltimore-based managing director and partner at HighTower, said in an interview in New York. He manages $750 million including bank stocks. "Add to that the risks to the sector that investors saw earlier have been alleviated by global central-bank action."
Sales of previously owned U.S. homes climbed in April to the highest level in more than three years, while new homes rose to the second-highest level since 2008, reports showed last week. The Fed pledged to continue its bond-purchase program.
The S&P 500 Financials Index's rally this year, the biggest after health care stocks, compares with a 16 percent advance for the broader stocks gauge. Financial firms in the S&P 500 reached their highest level since October 2008 on May 21. Still, they trade at 13.3 times earnings forecast in the next year, 11 percent less than the S&P 500, data compiled by Bloomberg show.
Analysts estimate the companies, from lenders JPMorgan Chase & Co. and Bank of America Corp. to insurers such as MetLife Inc., will earn $20 a share excluding some items this year, data compiled by Bloomberg show. That would be the most since $24.03 in 2007.
"The outlook for the industry is quite good and earnings are likely to go up," Richard Bove, a bank analyst with Rafferty Capital Markets LLC, said in a May 24 phone interview. "The economy is going to do well in the second half of this year and that means more mortgages, more auto loans, more commercial loans, more credit-card loans. It makes a lot of sense for the XLF to be up, and it's likely to go higher," he said, referring to the financial ETF's ticker symbol.
JPMorgan, the largest U.S. lender and the biggest company in the ETF with an 8.5 percent weighting, said on April 12 first-quarter profit climbed 33 percent to a record. Warren Buffett's Berkshire Hathaway Inc., the second-largest weighting in the fund, posted earnings that rose 51 percent on May 3.
Low interest rates and the threat of stiffer regulation are making financial stocks unattractive, according to Peter Sorrentino, who helps manage about $14.7 billion at Huntington Asset Advisors in Cincinnati.
The Fed has kept its main interest rate in a range of zero to 0.25 percent since December 2008. Net interest margin, a measure of lending profitability, dropped to about 3.1 percent in the first quarter, the lowest level since 2008, according to St. Louis Fed data on U.S. banks with average assets greater than $15 billion.
"Our view is that economic growth is anemic, and we just don't see that much in the way of loan demand while net interest margin continues to be compressed under this Fed policy," Sorrentino said in a May 24 phone interview. "There's a lot more regulation coming down with Dodd-Frank and we tend not to want to get into situations that have gone political like that, so we're kind of eschewing the banks as a whole."
New rules for trading, clearing and business conduct are being created under the 2010 Dodd-Frank Act designed to prevent a repeat of the 2008 financial crisis.
The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 option prices known as the VIX, dropped 2.9 percent to 13.59 at 9:33 a.m. in New York today. Europe's VStoxx Index slid 4.6 percent to 17.33.
Implied volatility, which is used to gauge the cost of options, for three-month contracts with an exercise price 10 percent above the financial ETF, jumped 26 percent from its May 8 low to 16.67 at the end of last week, data compiled by Bloomberg show. That compared with a 3.4 gain to 20.79 for the measure for puts 10 percent below.
"XLF skew is low," Christopher Rich, head options strategist at JonesTrading Institutional Services LLC in Chicago, said on May 24. "The perception is that the central banks still have a safety net under equities and banks."