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Playing the Big Interest in Banks

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Goldman rally changes short-term sentiment.

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In my morning note for OptionSmith subscribers last Friday, I laid out the possibility for a big up day, writing:

"If the S&P presses below 875 but fails to bring in a fresh wave of buying, there could be a sharp snapback rally. When earnings hit full stride next week, all it will take is one or 2 good reports and a positive outlook to bring money off the sidelines and make a run back above the 900 level."

Investors didn't even need a strong earnings report -- just the anticipation of a big beat by Goldman Sachs (GS) was enough to light a fire under stocks yesterday.

The rally not only broke the downside momentum, but will likely cause a shift in short-term sentiment which had become increasingly bearish. It also pushes many options that had been out-of-the-money -- and had appeared ready to expire worthless -- back into play. With July expiration looming this Friday, traders will be making adjustments to positions that now carry more weight in terms of having higher deltas. This could lead to higher volatility in the next few sessions.

One the biggest and most obvious places this will occur is in options tied to the S&P 500 -- in which 900 is the big round number that carries the highest open-interest level. In SPX options, there's a good balance between puts and calls with about 130,000 contracts of each still open.

In the Spyder Trust (SPY), the $90 strike has 110,000 calls and over 200,000 puts. The fact that there are double the number of puts is indicative of how people generally use options on this ETF to buy portfolio insurance.

Following last month's expiration, I'd noted that the put protection in the June options hadn't been immediately replaced in the July series, and that that left the market vulnerable to a sell-off. Indeed, that's what occurred as the S&P descended from a 930 on the June 19 expiration and quickly fell to the recent 872 low.

More than half of the current open-interest in the June $90 puts didn't appear until after July 1, when the market had a big down-day and took out the 900 level.

It doesn't look like investors will make that same mistake again. The August series for the Spyder options with strikes between $85 and $95 already has over 700,000 puts open. This is compared to just 120,000 call options. This should provide a safety net and help underpin the market.

Big Interest in Banks

As mentioned, yesterday's rally seemed to be sparked by Goldman, and that helped the banking sector lead the way. This was accompanied by a surge in call buying in the Spyder Financial Select (XLF). The July $12 calls traded over 230,000 contracts yesterday and now have open-interest of 670,000; according to TradeAlert, this is the fourth-largest open-interest position this year.

Most of the buying came early and in large blocks, with the bulk being scooped up at $0.10-$0.12 a contract. The calls finished the day worth $0.22 -- a quick double.

It'll be interesting to see whether that massive open-interest acts as a lid, as those who own the calls can short stock. If the ETF runs through $12, that could force those short the calls to defend their positions by buying stock and causing a squeeze higher.
No positions in stocks mentioned.

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