The large U.S. banks are enjoying a notable rally, driven in large part by the results of the Federal Reserve Board's annual bank stress test. The test confirmed that the country's largest banks are well-positioned to weather a severe recession. As a direct consequence, current capital requirements will remain in place until 2027, when the next stress test is scheduled to be run. This outcome has fueled a strong move in banking stocks.
The Stress Test and the Sector Rally
Month-to-date, financials are the second-best performing sector, up 3.8%, trailing only Industrials, which are up over 4%. The financial sector has been on a good run, and part of this strength is tied to the heavy underwriting activity that has accompanied a "summer of IPOs." The banks are also among the first companies to report as earnings season gets underway in earnest over the coming weeks.
The stress test result itself was not particularly surprising. The stress tests have, for many years, been an exercise that banks have come through strongly. Over the last several years, all the banks have passed, effectively flying through with flying colors while maintaining their capital requirements despite large modeled losses. The Fed does periodically change its "severe adverse" scenarios; this year it increased the severity of a few while decreasing others, but the banks still performed quite well.
The Upside Surprise: Dividend Increases
While the stress test result was expected, the dividend increases this year came as a bit of an upside surprise. Among the banks that reported immediately following the test, dividend increases averaged 13%, compared with 10% the prior year. This suggests banks are feeling more comfortable about the operating environment. The favorable backdrop around second-quarter earnings, combined with the year-to-date uptick in capital markets activity, has given them the confidence to raise these dividends.
A Strong Setup for Second-Quarter Profits
Large bank profits in the second quarter are expected to be among the best in recent memory, thanks largely to capital markets revenue. For the largest, most capital-markets-sensitive banks in the nation, business has been "running on all cylinders." Several distinct drivers are contributing to this strength:
Investment banking. Equity issuance, IPO activity, and mergers and acquisitions advisory work are all performing extremely well, each for different reasons. There have been some mega IPOs — notably the SpaceX IPO, which generated several hundred million dollars in fees divided among the underwriting banks. With over 20 underwriters on the SpaceX IPO alone, the benefit is being felt across the industry in a positive way.
Mergers and acquisitions. M&A activity has improved as corporates take advantage of a somewhat lighter regulatory environment under the Trump administration, pushing more deals through.
Trading revenues. Trading on the capital markets side has benefited from heightened volatility — driven by the Iran conflict and broader geopolitics. This is not confined to equity markets; the energy market, other commodities, and currencies have all been volatile, which is beneficial for banks.
Fixed-income issuance. A massive build-out of AI infrastructure and data centers is prompting large companies to tap the fixed-income market. Banks have been beneficiaries of all that issuance.
The Lending Side and Credit Quality
The lending business is less exciting by comparison, with loan growth running in the low-to-mid single-digit range. However, credit quality is good. The U.S. labor market remains healthy with low unemployment, which is a key indicator that delinquency rates and similar measures will stay low. Worries about credit quality typically arise whenever unemployment ticks up, but that has not been the case. As a result, large increases to loan loss provisions are not expected, which is positive for bank profitability. The economic data is holding up, and banks have reported in recent quarters that the consumer is hanging in there as well — something that will be tested again when banks begin reporting in a couple of weeks.
A Sample Options Trade on JP Morgan
JP Morgan hit all-time highs after its announcement of a dividend raise and a $50 billion buyback. With earnings due in just over two weeks, that event has to be factored into any trade. The July 17th monthly option series — expiring in 22 days at the time — carries higher implied volatility because of the upcoming report.
Given that the stock had already run up fairly far and fast into the earnings event, one approach is to take advantage of the elevated implied volatility while still expressing a directional bias. The example here is a neutral-to-bullish short put vertical, which captures the high implied volatility heading into the report while providing a cushion in case the stock pulls back from its elevated levels.
The specific structure: in the July 17th monthly options, sell the out-of-the-money 330-strike put — out of the money by over $10 to the downside — and, to stay risk-defined on this high-priced stock with built-in event risk, buy the 320-strike put. This creates a $10-wide neutral-to-bullish put vertical.
The trade collects roughly a $250 credit per spread, which is the maximum gain, against about $750 of risk. It pushes the break-even all the way down to $327.50 over the next three weeks — just over 4% below the current share price — providing a meaningful downside cushion before losses begin. The probability that the short 330 strike finishes out of the money at expiration is over 66%, giving a higher probability of success. This illustrates the classic tradeoff: a trader is willing to make only $250 with $750 at risk in exchange for an over-4% downside cushion and a higher probability of success — all by taking advantage of high implied volatility going into the earnings event with a neutral-to-bullish short put vertical. On the day of this trade, financials were up about 1.5%.
