*Citi January butterfly spread calls for rally by Jan
*BofA traders buy puts fearful of continued losses
*Financial ETF Oct $10 puts stand out
NEW YORK/CHICAGO, Aug 18 (Reuters) - Option traders on Thursday zeroed in on Citigroup and Bank of America as bank stocks were roiled in Wall Street's selloff on Thursday.
Banks came under pressure after European firms were hit hard on worries about short-term funding. Money markets, the arteries of the financial system, are showing increased stress. For details, see [ID:nL5E7JI0Q]
"With the banking sector alone down 5 percent in the overall market, two components accounted for a majority of the option activity -- Bank of America (BAC.N) and Citigroup (C.N)," said Patrick Mortimer, director of options trading at Pipeline Trading Systems in New Hope, Pennsylvania.
Two trades each in Citi and BofA accounted for four of the top 10 largest option trades on Thursday, according to Trade Alert, but activity shows investors more positive on Citigroup and less so on Bank of America.
Wall Street tumbled on Thursday, with the Dow falling more than 3 percent and the S&P 500 dropping more than 4 percent. The KBW Banks Index .BKX fell 5.6 percent.
"There is still much concern in the financial sector that the European financial crisis will spread to the U.S. and significantly hit hard the balance sheets of some of our larger banks," said TD Ameritrade chief derivatives strategist J.J. Kinahan.
In BofA, more than 71,000 November $4 puts changed hands, with nearly all the trading taking place mid-market or on the offers. "The strike's open interest is 10,500 contracts so a majority of the trading is by investors opening new positions, bracing for further downside in the shares," Mortimer said.
Investors have been buying BofA puts over the last two weeks, which could be a hedge or speculative positions, Kinahan said.
Traders started with the August $9 puts in the first week of August when shares traded just over $9. "Since that time, particularly over the last few days, we have seen many buyers of the $6 and $7 August puts," Kinahan said.
Bank of America (BAC.N) shares fell 6 percent to $7.01 on Thursday, down 28 percent for the month.
Citigroup, on the other hand, attracted a large bullish butterfly trade, which targeted gains by January.
A January $35-$42-$49 call butterfly appeared to be initiated as a new transaction. It was bought at 95 cents and was tied to a block of 340,000 shares at $28.52, said WhatsTrading.com options strategist Frederic Ruffy.
A so-called butterfly is a limited risk, limited reward strategy that makes money if the stock closes within a particular range -- the "wings" of the butterfly -- by the end of the contract expiration.
The spread offers a maximum payoff if shares rally to $42 through the January expiration. The break-even point of the trade was $35.95 at expiration.
The size of the spread, accounting for a total of 102,000 contracts, pushed call volume to nearly three times the put volume, according to options analytics firm Trade Alert.
Citi shares ended down 6.3 percent at $27.98.
In the Financial Select Sector SPDR Fund (XLF.P), traders have been buying puts all week and the pattern continued on Thursday, Kinahan said.
"Bank stocks are the drowning victim and there is fear that they could drag the market into a major recession," said Mark Sebastian, chief operating officer of options education firm Optionpit.com in Chicago.
(Editing by Kenneth Barry)