Financial Services Sector Trading Strategy (Backtest And Example)

Last Updated on August 12, 2022 by Oddmund Groette

With the tight regulations that followed the 2008/2009 financial crisis, this sector has been stable with steady growth. But let’s see what it has to offer.

In this article, we discuss the US financial sector and we show you an example of a financial services trading strategy. The sector is great for trading due to the high volatility.

What is the S&P Financial Services sector?

The S&P 500 Financial Services sector consists of those companies included in the S&P 500 that are classified as members of the GICS Financial Services sector. The companies in the sector provide financial services to individuals, SMEs, and corporations. They include the traditional banks, investment houses, and insurance firms, as well as the recently growing fintech industry.

A capitalization-weighted index of this sector is tracked by Vanguard Financials ETF (VFH) and Financial Select Sector SPDR Fund (XLF).

What are the 5 biggest stocks in the sector?

Five of the biggest stocks by market capitalization in the S&P financial sector include:

Berkshire Hathaway Inc. (BRK-A) and (BRK-B): Through its subsidiaries, the company invests in different kinds of business, including insurance, freight rail transportation, and utility businesses, all over the world. There are two classes of Berkshire Hathaway stock: Class A (BRK-A) and Class B (BRK-B). Class A stocks have voting rights and are more expensive than Class B stocks which do not have voting rights. As of July 21, 2022, Berkshire Hathaway Inc. has a market capitalization of $631.802B.

JP Morgan Chase & Co. (JPM) and (JPM-PC): JP Morgan Chase & Co. is an American multinational financial service provider. It is the largest bank in the United States as of 2022, and the largest bank in the world by market cap. As of July 21, 2022, JP Morgan Chase and Co. (JPM) and (JPM-PC) have a total market cap of $336.74B and 343.162B respectively.

Bank of America Corporation (BAC-PK): Through its subsidiaries, the bank provides banking and financial products and services for individual consumers, small and middle-market businesses, institutional investors, large corporations, and governments worldwide. It also offers investment services and products, residential mortgages, and home equity loans. It has a market cap of $253.827 billion as of July 2022.

Citigroup Inc. (C): The bank provides various financial products and services to consumers, corporations, governments, and institutions in North America, Latin America, Asia, Europe, the Middle East, and Africa. Operating via its Global Consumer Banking (GCB) and Institutional Clients Group (ICG) segments, the bank offers traditional banking services to retail customers, including Citi-branded cards and Citi retail services, and lending. It also provides investment services through a network of local branches, offices, and electronic delivery systems, as well as offers wholesale banking products and services, including fixed income and equity sales and trading, foreign exchange, prime brokerage, and corporate lending. Its market cap as of July 21, 2022, is $146.347 billion.

Goldman Sachs Group Inc (GS): This financial institution provides a range of financial services for corporations, governments, and individuals worldwide. It offers investment banking, global markets, asset management, and consumer & wealth management. Its services include financial advisory services, such as strategic advisory assignments related to mergers and acquisitions, divestitures, corporate defense activities, restructurings, and spin-offs. As of July 21, 2022, its market cap is $110.401 billion.

However, by the time you read this article, the 5 biggest financials stock might have changed.

Financial stocks and the financial crisis 2008/09

The financial sector collapsed during 2008/09. Just look at this chart of XLF:

Financial stocks during GFC 2008/09
Financial stocks during GFC 2008/09

From the peak in 2007 the sector fell 85% before it bottomed. Perhaps needless to say, but many stocks went belly up and many were “bailed out.” The ETF still trades at the same level as in 2007! However, the above chart doesn’t include paid out dividends.

Because of this, many investors shun the sector today. But the sector has changed dramatically and it has further consolidated. The sector today is completely different compared to what it used to be.

Financial sector trading strategy (XLF trading strategy)

Let’s go on to backtest a trading strategy for the financial sector. We use the ETF with the ticker code XLF as a proxy for the financial sector.

The first trading strategy we use is based on the monthly trading edge from August 2021. We have changed the criteria slightly, though. We regard the strategy as a volatility strategy and is included in our 3 volatility strategy bundle.

The equity curve for XLF looks like this:

Financial sector trading strategy and backtest (XLF trading strategy)
Financial sector trading strategy and backtest (XLF trading strategy)

There are 198 trades, the average gain is 1.05%, the win rate is 73%, max drawdown is 21%, and the profit factor is 2.25.

We believe these numbers are pretty good. The trading strategy works well for almost all stock indices. However, it doesn’t work for commodities.

Financial Services Sector Trading Strategy – remarks

When you are backtesting the financial services sector, please keep in mind that the sector has a high correlation to the overall market. The overall market is represented by S&P 500 or Nasdaq 100.

If you want to succeed as a trader you need to understand the value of non-correlation and trading strategies that complement each other. This is a topic we have covered in many articles:

That said, the XLF and the financial services sector is a great trading vehicle due to the high volatility, and the financial services trading strategy provided in this article is a great example of that.

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