Take a punt on how much further British banking stocks can rise

THE Bank of England&rsquo;s secret deal which saw it lend ailing Royal Bank of Scotland and HBOS an astonishing &pound;61.6bn last October was a timely reminder of just how bad the situation was this time last year. <br /><br />The global financial system was struggling to rebalance itself and many banks had either collapsed entirely or been taken over by other, stronger ones. And even the lucky few that escaped much of the sub-prime and derivatives chaos saw their share prices plummet as the wider market slumped.<br /><br />But in the same way that banks led the markets down, they have also been at the vanguard of stocks&rsquo; precipitous rise since March. Barclays, which managed to avoid taking taxpayers&rsquo; money, has risen 516 per cent since its low in late January. Another British bank that has remained outside the government fold is HSBC, which is up 111 per cent. Even part-nationalised RBS and Lloyds Banking Group have managed to rise 249 per cent and 97 per cent.<br /><br />But these sharp rises are starting to be called toppy by some analysts, who are questioning how much further upside can realistically be expected. Risk aversion is creeping back into the markets and there are still lingering concerns that we may see another drop. <br /><br /><strong>FUTURE PROFITABILITY</strong><br />Strategists at investment firm Exane think that most of the good news seems to be priced in to the banking sector. They point out that the sector has underperformed since the end of August, despite consensus-beating third quarter earnings and argue: &ldquo;Given that future profitability is likely to be lower because of regulatory constraints, the sector offers limited upside&rdquo;.<br /><br />If you agree with them and think that the likes of Barclays and HSBC have risen too much too quickly, then you may want to consider a put covered warrant &ndash; the right but not the obligation to sell the stock at a pre-agreed price on a pre-determined date on these stocks with a strike price of say 250p on Barclays, which is currently trading at 315p. <br /><br />However, it would be highly risky and expensive to buy put warrants with an expiry date of December 2009. Instead, traders who expect banks to pull back in the New Year might be better off choosing a warrant with a similar strike price but with a maturity of December 2010, which removes the risk posed by deteriorating time value. <br /><br />You could also use put covered warrants to hedge existing long positions in the banking sector, whether they be physical shares or other derivative positions, as your maximum potential losses will be limited to the cost of buying the covered warrants rather than the unlimited losses that other products can expose you to. <br /><br />Whether you want to take a speculative punt on the banks consolidating at a lower level or hedge your positions, then put covered warrants on UK banks &ndash; there is as yet no covered warrant on the sector index &ndash; are the way forward.