Trade This Financial ETF for a +30% Potential Profit

Now may be the optimal time to trade the financial sector.

During the week of April 16, shares of many financial companies fell, following news of fraud charges against The Goldman Sachs Group, Inc. (NYSE: GS). As a result, many financial stocks can be picked up at lower prices, compared with a couple of weeks ago.

Strong recent earnings news from JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC) and Citigroup, Inc. (NYSE: C) show the financial sector is springing back to life after the pummeling it took from 2008 to 2009.

Combine these factors with increasing investor and consumer confidence, as well as better consumer credit ratings, and the outlook for the financial sector seems bright.

Exchange-traded funds (ETFs) — which track the overall movement of a sector — present an excellent way to trade the financial sector.

The Financial Select Sector SPDR (NYSE: XLF) replicates the financial sector of the S&P 500. It is the largest and most widely traded financial ETF, comprised of 79 of Wall Street’s most notable financial companies.

The fund’s top-ten holdings include the Bank of America, comprising 10.2% of the ETF, and JPMorgan Chase at 10.0%. Wells Fargo & Co. (NYSE: WFC) comprises 9.5%, Citigroup is at 5.3%, and Goldman Sachs is at 4.8%.

Other major fund components include diversified financial service companies (comprising 30.4% of the fund), commercial banks (20.0%), capital markets firms — which trade debt and equity securities — (19.2%), and insurance firms (15.8%).

Currently, XLF is up about +11% year-to-date, making it one of the top-performing financial ETFs. XLF also provides an annual dividend of $0.34, giving it a yield of 1.2%. The ETF has an expense ratio of a mere 0.22%.

Technically, XLF shows strength. Since bottoming out near $5.75 in March 2009, the fund has, so far, climbed +192% to $16.78. And, it remains in a strong uptrend.

In late August, XLF began consolidating in a narrow range between support near $13.50 and resistance near $15.50.

However, in early March XLF pierced resistance, breaking an eight-month rectangular consolidation pattern and completing a bullish ascending triangle that had begun in February.

#-ad_banner-#XLF is currently above its rising trendline, about $15.50, as well as the 10- and 30-week moving averages. In March, the rising 10-week moving average crossed over the 30-week moving average — a bullish sign.

The stock is also climbing the upper Bollinger band. If XLF can pierce its upper Bollinger band, the next major resistance area is near $17.15, near where the upper channel line intersects.

The indicators are bullish. The MACD histogram is climbing higher in positive territory, giving a buy signal.

The index (RSI) has been on a sustained uptrend since March 2009. While RSI is just about to test overbought levels, it is not there yet.

Stochastics shows the stock is overbought; however strong securities can become and stay overbought for long periods of time.

From a fundamental perspective, XLF shows earnings growth potential, fair valuation and an increasing return on equity.

In 2009, the earnings per share of the fund’s holdings were $0.45. This year, nearly +107% growth is expected, with earnings reaching $0.93. For 2011, analysts project another +47% increase, with earnings reaching $1.37.

With a price-to-earnings ratio (P/E) of 17.1 and a price-to-book ratio (P/B) of 1.0, the fund is fairly valued. In comparison, the Dow Jones U.S. Financial Services Index Fund (NYSE: IYG) –which seeks to replicate the financial services sector of the Dow Jones Industrial Average — has a P/E ratio of 22, and a P/B of 1.9.

Analysts also project XLF will have a growing ROE was 3.2%. This year, analysts expect ROE to nearly double to 6%. By 2011, ROE is expected to increase another +40% to 8.4%.

These technical and fundamental factors make XLF an appealing choice for trading the financial sector.

However, I will cautiously enter the position. A proposed bank tax combined with the proposed financial regulatory reform bill brings uncertainty into the situation — especially in light of the Goldman Sachs charges.

For my top individual financial stock pick, see this week’s issue of my Double-Digit Trading newsletter.