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Soaring Popularity of Bank Loan ETFs Indicates Investors Are Expecting Interest Rates to Climb Higher

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Due to fears of rising interest rates, speculators have been running toward exchange-traded funds designed to have low sensitivity to interest rates. The PowerShares Exchange-Traded Fund Trust II is one such fund.

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PowerShares Exchange-Traded Fund Trust II (NYSEARCA:BKLN) closely follows the movements of the S&P/LSTA US Leveraged Loan 100 Index. In turn, the index is designed to reflect the largest facilities in the leveraged loan market.

Recently, investors have been increasingly skeptical of the ability of US capital markets to continue their seemingly neverending climb. Many market participants seem to believe that the markets' strength is directly tied to the Fed. For this reason, speculators are more focused on any news regarding future monetary policy than they are on the market itself. This has led investors to adjust their ETF portfolios in order to try to hedge their risk if interest rates do go up.

Due to fears of rising interest rates, speculators have been running toward exchange-traded funds designed to have low sensitivity to interest rates. BKLN is one such fund. It invests in senior loans, which are basically high-yield bonds with floating interest rates. When bank loans have a floating rate, they typically reset every one to three months based on short-term interest rates.

Last week, BKLN saw an inflow of approximately $147.4 million, which is a 3.4% increase week over week in outstanding units, according to ETFChannel.com. Furthermore, this year alone, the fund has raked in an impressive $2.7 billion in addition to $1.5 billion in previous assets. The ETF pays out a 12-month yield of 4.7% and has posted total returns of about 3%. BKLN has been consistently trading above its 200-day moving average throughout the year.

The soaring popularity of bank loan ETFs indicates that investors are expecting interest rates to climb higher -- if not immediately, then definitely in the near future.

The "Institutional Trade": As an example, one trader bought 3,000 BKLN Oct 24 puts for $.30.
Risk: $30 per one lot
Reward: $2,370 per one lot
Breakeven: $23.70
Cash Outlay: $90,000

My Trade: Buying the BKLN Jan 2014 25 calls for $.10.
Risk: $10 per one lot
Reward: Unlimited
Breakeven: $25.10

(Disclaimer: I am long the BKLN Jan 2014 25 calls for $.10.)

Unusual Option Activity

We define unusual option activity as large block trades that represent a large percentage of daily option volume. The block trade is considered "unusual" if the option volume is above the average daily volume over the past 22 days. At my firm, we scan and analyze order flow from all of the major options exchanges in order to identify any unusual option activity.

Analyzing unusual order flow gives traders a window into what the positions that large institutional players have. The majority of unusual option activity can be traced back to hedge funds, mutual funds, and other large institutions. Knowing where these institutions are placing their bets can be hugely advantageous for any trader. These institutions have informational and technological advantages that the average trader doesn't have, and the amount of time and analysis that goes into every one of their trades is substantial.

Order flow can however at times be deceiving. One might logically thing that a large block buyer of calls is bullish on the underlying. This is not always the case. Remember that a large number of participants in the equity options market are hedgers. Long calls are a hedge against short stock, and long puts are a hedge against long stock. With this in mind, my firm has developed a 7-step trading plan that helps filter out unusual option activity that will not provide actionable trade setups. It is by using this plan that we are able to identify the most significant unusual options activity trades every day.
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Author is long the BKLN Jan 2014 25 calls for $.10.
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