Trading in bank index options has surged as bank stock investors seek ways to insulate their portfolios amid rising uncertainty over the federal budget and interest rates.

Through the first nine trading days of 1996, the Chicago Board Options Exchange has recorded 13,634 S&P bank index trades, nearly matching the 17,712 trades for all of December.

Industry observers said rising interest among institutional investors in the Standard & Poor's bank index option contract reflects a desire to hedge bank stock positions while waiting for the market to stabilize.

"I think it's symptomatic," said James McDermott, a banking industry analyst with Keefe, Bruyette & Woods Inc. "A lot of investors made a lot of dough in 1995 and previous years in this group, and now they're hedging their bets."

He predicted that trading volume in bank index options will be strong "until the dust clears and there is a better feel for who is going to do well in 1996."

Over the past year, the index has mirrored investor gains from the banking sector. It rose nearly 50% last year, from around 215 in January 1995 to a little over 330 at yearend, but had retreated to just over 314 at the close of trading on Jan. 12.

Trading volume in the index started to rise in November, and has picked up even more steam since the beginning of January.

Brian Donnelly, a trader with Chicago-based Hull Trading Co. and the designated primary market maker in the bank index, said much of the trading activity in the index has come from institutional investors buying what are called put spreads.

In such a contract, the investor buys a put option - betting that the index will fall - while simultaneously writing a new put option - betting that the index will rise.

Some institutions have placed large orders to accomplish this kind of hedge. Mr. Donnelly said he has recently seen orders as large as 7,500 contracts. At current market prices, an order of this size has a notional value of nearly $232.5 million. The investor pays only a small fraction of that amount to control these contracts.

"I think it's people who don't want to spend a lot of money for protection, but at the same time would like to protect a portfolio by giving it a downside hedge in case the index sells off," Mr. Donnelly said. With this strategy "there is some downside protection, but unlike a naked put, it's not unlimited downside protection."

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