The second quarter has been very good to Canadian banks. Since the March 9 low, the S&P/TSX Capped Financials Index has rallied 69%, while the S&P/TSX Composite Index has advanced 36%. With credit markets thawing, costs under control, capital ratios high, earnings in a positive trend, the threat of dividend cuts fading, Canadian bank shares have been thriving in the proverbial sweet spot since March.

Surprisingly this flies in the face of so-called conventional wisdom. Over the past twelve months, many experts have suggested that financials caused the crisis, and therefore would not lead a recovery.

As with past bubbles, so went the logic, the sector causing the problem is the last sector to recover. Examples include technology stocks that have yet to recover from the 1990’s bubble, commodity and oil stocks after run ups in the late 70s and of course, the 2007 collapse in real estate stocks.

The problem with this thesis is that it ignores the unique place financials hold in the economy. Banks provide the credit that lubricates the economic engine, and without that, a recovery is not possible. Which is why recoveries are typically lead by the financials, and why this one will not be any different.

That said, I find value in the proposition that bank shares have risen to fair value, and in some cases, beyond fair value. Clearly, second quarter results due in July will provide detail as to the health of Canadian banks. And more importantly, what if any, upside potential exists.

Option traders who are long bank shares, may want to hedge their positions going into earnings season. And the best hedge at this point seems to be a long put strategy.

Not surprisingly, as Canadian banks have stabilized, option premiums have fallen sharply. For example, at-the-money options on Bank of Montreal (TSX: BMO; +108% since March low) are trading at 22% implied volatility, well down from the 60% implied in March. Similar numbers exist with options on Royal Bank of Canada (TSX: RY; +91% since March low) and iShares CDN Financial Sector Index Fund (TSX: XFN; +75%).

If you want to hedge positions through the earnings season, look at the at-the-money August puts. With Bank of Montreal at $49.02, the BMO August 48 puts at $1.75 or better would be a reasonable hedge. Similarly, with Royal Bank at $47.99, the RY August 48 puts at $2.10 or better (implied volatility 30%) look interesting.

Another approach, rather than trying to hedge the individual stocks, is to buy puts on the sector… specifically the iShares CDN S&P/TSX Financials Index Fund. With XFN at $19.75, you could look at buying the XFN August 20 puts at $1.00 or better (implied volatility 28%).