The accelerated expectations for the Federal Reserve to raise its overnight lending rate have installed a cloud over companies that are interest-rate sensitive, like financial services firms. Large banks have been hit particularly hard, with the Philadelphia Bank Index (BKX) down 23% and the S&P Financial Trust (XLF) - Get Report falling 12%, over the last four weeks.

Darkening the picture was

Citigroup's

(C) - Get Report

recent decision to fork over about $2.65 billion to settle class-action suits related to the involvement of its investment banking and research departments (and never shall the twain meet again) in the

Enron

and

Worldcom

fiasco. This move had investors thinking that other banks, namely

J.P. Morgan

(JPM) - Get Report

, will need to boost its set-aside money to pay for the roguish roles they played in that web of investor deceit.

Certainly rising rates and litigation are potential negatives for these companies, but I think the near-term reaction is overdone and that fears about the ultimate impact are overblown. I view this as an opportunity to start building a bullish position in these franchise names that dominate the industry.

Not So Certain? Use Dispersion

One way to get into some long positions with minimal risk would be to use a simplified version of the dispersion trading strategy. This involves buying options on an index- or exchange-traded fund while selling the options of the individual issues that comprise the index. The theory is that component issues will have higher implied volatility than the implied volatility on the overall index.

This article of mine on

dispersion trading from last July, provides not only more details of the concept but also includes an example applied to the

Semiconductor HOLDRs Trust

(SMH) - Get Report

.

What I suggested was selling short SMH puts while buying puts on three of its individual components:

KLA-Tencor

(KLAC) - Get Report

,

Teradyne

(TER) - Get Report

and

Novellus

(NVLS)

. My premise at the time was that the sector had recently racked up major gains, with the SMH having moved up 32% to $31 in the prior three months, and that the above-mentioned individual issues might be particularly susceptible to a major stock decline. The theory was that the weight of those three stocks accounted for only about 6% of SMH's price -- a tumble in them would not necessarily bring down the SMH by an equal price percentage basis.

The result was that the SMH and all the components mentioned were at higher prices when their August options expired just five weeks later, producing a modest profit equal to the total premium collected or the position's initial net credit. A minor victory, and also consistent with the fact that dispersion trading is a game of inches; this one gained a few.

I think where I went astray was using a short time frame and offsetting the SMH position with issues that carried little weight in its pricing. If I had bought options with a longer life span, it would have allowed for the thesis to play out.

As it turns out, current prices show that the short SMH puts would still be out of the money and essentially worthless, while the ultimate decline in the share price of KLA-Tencor and Novellus have sent their long puts into the money, giving them an intrinsic value of about $8 and $7, respectively. Oh, those would have been salad days! But enough rehashing of leftovers; it's time to look for ways to take the current market roughage and create a feast of profitability.

Getting Larger and Longer

This time, the more attractive strategy will look to take advantage of the greater discrepancy between implied volatilities. Citigroup and J.P. Morgan puts are currently sporting implied volatilities of 25% and 28%, respectively, both of which represent their highest levels in the past 52 weeks and well above the historical average of 10%. Put options on the BKX currently have an implied volatility of 19%. While that's at the upper end of its range, it's only moderately higher than its historical average of 12% over the last 52 weeks.

I also want to take advantage of Citigroup and J.P. Morgan accounting for nearly 30% of the weight of the 24 companies that comprise the index. If you include J.P. Morgan's recently approved acquisition of

Bank One

(ONE) - Get Report

, that weighting will go up to 35% of the index. This means I only need to sell puts in two companies (that I'm willing to buy at lower prices) to essentially track the BKX, which keeps the number of transactions and commission costs down.

Here is a suggested strategy:

  • Sell one Citigroup September $42.50 put for $1.45; this gives an effective purchase price of $41.10, or a 9.2% discount to current prices.
  • Sell one J.P. Morgan September $32.50 put for $1.40; this gives an effective purchase price of $31.15, or an 11% discount to today's already-beaten-down price.
  • Buy two BKX $88 puts for $2.80 each, giving a break-even point (or the level at which you are short the index) of $85.20, or just 6.8% below today's price.

The position has a net cost of (or debit of) $2.75, or $275, per unit; if you sold two Citigroup and J.P. Morgan puts and bought four BKX puts, it would cost $550 or debit to establish.

The theory behind this strategy is that selling puts is a nice way to back into owning two of the largest and most stable financial stocks, which also happen to pay dividends. Buying the puts on the BKX index gives you a certain measure of protection that should prevent you from incurring any losses or drawdown of capital as the individual stock price's decline toward your targeted purchase price.

If you're more bullish on the financials you can easily adjust the strategy by selling closer-to-money puts on Citigroup and J.P. Morgan or buying just one BKX put to create a less costly and higher purchase price. Conversely, a more bearish view can be accommodated by increasing the number of BKX puts purchased.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.