Canadian banks basically got a straight-A report card from rating agency Standard & Poor’s Corp. It announced results of its stress tests on Canadian banks last week, and reported that Canadian financial institutions are well capitalized and performed better in stress tests than US banks under similar tests.

This is a major vote of confidence for Canadian banks and is bound to increase investor interest in Canadian bank stocks. In addition, Canadian banks have reported better-than-expected quarterly earnings, as cost-saving measures kick in and credit-market-related writedowns dwindle.

Risks in the banking sector seem to be abating. Note for example, the narrowing TED Spread. The TED spread is the difference between the interest paid on US Treasury bills and the yield on interbank loans, which is LIBOR. The TED spread is the best measure as to how the market quantifies the risks associated with inter-bank lending. A narrowing TED spreads indicates lower risk in the banking sector and by extension, a positive sign for bullish traders.

Even with the recent run-up, Canadian bank shares are still paying an average dividend around 4.4%. Consider that earnings are improving, it would not be a surprise to see Canadian bank price-earnings multiples expand in the second half of the year.

Option traders might consider taking bullish options positions on individual Canadian bank stocks, such as Bank of Montreal (TSX: BMO), CIBC (TSX: CM), Toronto-Dominion Bank (TSX: TD), and Bank of Nova Scotia (TSX: BNS).

Not surprisingly, the cost of options on bank stocks has been declining. As the risks diminish, options begin to trade at lower implied volatilities. Which means that option buying strategies probably make the most sense tat this stage.

Option traders might consider three to six-month calls on the aforementioned bank stocks. For example, with BMO, you could look at the BMO January 54 calls at 3.25. With CIBC at $66.31, consider the CM January 66 calls at 4.55.

Toronto-Dominion closed Friday at $63.11. The TD January 64 calls look interesting at $3.55. And finally, with BNS at $45.92, look at the BNS January 46 calls at $3.30.