Options in financial ETF becomes a crowd favorite

By Doris Frankel

CHICAGO (Reuters) - Traders flocked on Friday to put options in an exchange-traded fund tracking the performance of the financial sector on renewed fears that credit problems could create further fallout in the battered sector.

The increased number of bearish bets in the Financial Select Sector SPDR fund XLF.A may also be the result of U.S. regulators' crackdown on short selling, affecting the shares of 19 major financial firms.

Roughly one million options traded in the XLF, with puts outnumbering calls by a factor of 1.71, topping its normal level of 840,000 lots, according to Trade Alert.

The XLF, which holds the financial-related components from the Standard & Poor's index, was the option crowd's top favorite, data from option analytics firm Trade Alert showed.

"The put trading we are seeing in the XLF is protection against a further sell-off in the financial sector, as well as a slight increase in speculative trading on continued weakness in the overall market," said Al Greenberg, head options trader at broker-dealer BNY ConvergEX Group.

Fundamentally, concerns about the impact of the housing slump on the economy and the health of U.S. banks are still hanging over the sector.

"People are worried about credit quality and the potential for additional failures in the banks," said Scott Fullman, director of derivative investment strategy at broker-dealer WJB Capital Group.

SHORT RULE WILD CARD

But the increase in put volume in the XLF also coincides with the U.S. Securities and Exchange Commission's emergency rule to curb abusive short selling that took effect on Monday.

"We might be seeing increased put volumes because of continued fear in the sector, but also because of the short selling restrictions that are now in place in the equities market," said Joseph Cusick, senior market analyst at online brokerage OptionsXpress Holdings Inc.

"If there is someone who has a basket of these financial services securities, they could be using the puts in the XLF as a hedge."

Investors often turn to puts, conveying the right to sell the security's shares at a given price and time, to protect against adverse losses in the underlying stock.

The SEC rule requires an investor to borrow shares before executing a short sale and to deliver the securities by settlement date.

Short selling is a legitimate trading strategy where an investor arranges to borrow securities they believe are overvalued and sells them in hopes of making a profit when the price drops.

The SEC is targeting "naked" short selling, which occurs when an investor fails to borrow the stock ahead of time. It can be illegal if done intentionally.