Sometimes the very best trading opportunities are born from the market’s over-reaction to a mere possibility. Case in point - the iShares S&P US Preferred Stock Index Fund (PFF). Investors felt the dividends being paid by many preferred stocks were in jeopardy, thanks to the stipulations likely to be included as part of the government’s bailout package. As a result, the stock was torpedoed a couple of times in the last few weeks. However, the most recent plunge - if like the last two - could be setting up a nice, trade-worthy rebound.

The pattern is really quite simple … PFF works its way into an oversold situation, and then bounces sharply by 10 points or more. We’re using a stochastics chart as an oversold/overbought indicator, which as you can see has been a very effective trading tool for PFF since October. More specifically, the iShares S&P US Preferred Stock Index Fund is bouncing around in a rising trading range, and we’ve just seen it push off the lower edge of that range.

The counter-argument is valid … preferred stock dividends are truly at risk, and in the case of the banks may be going away entirely under some versions of the ever-changing stimulus proposal. As such, PFF isn’t attractive.

It’s not an invalid argument, but we have two responses to it.

First, this isn’t a long-term trade idea. In fact, it’s specifically a short-term idea. Besides, the threat to dividends started long before either of the last three pullbacks, and we’ve seen two rallies following sharp drops despite the continued risk that government intervention poses. So, the question really isn’t one of value … if the index isn’t ‘worth it’ now, it wasn’t worth it in October or December either.

The second reason the iShares S&P US Preferred Stock Index Fund isn’t under as much duress as investors might think is simply that many of the biggest preferred stock holdings that make up the fund aren’t banking or financial stocks. Lots of other companies are represented in the ETF, like Freeport-McMoran Copper & Gold (NYSE: FCX), Metlife (NYSE: MET), and Schering Plough (NYSE: SGP). However, even the fund’s holdings in Citigroup (NYSE: C) and US Bancorp (NYSE: USB) preferreds could be better served with help from TARP than without it. Indeed, the worst for those stocks may already be priced in.

Additionally, as the economy’s footing becomes more encouraging, odds are good that dividend-paying equities are going to be much more attractive during the rebuilding phase. This further bolsters the short-term argument in favor of PFF, even if it is a longer-term rationale. This idea could also be part of the reason the ETF has made higher highs and higher lows since October …  this is one group of stocks investors are quick to buy on a dip.

In any case, the iShares S&P US Preferred Stock Index Fund simply looks like a high-odds trade that could produce some relatively easy money. We’re not shooting for the stars, and of course we’re keeping the trade on a short leash. The chart, however, hints the market is trying to repeat the gift of gains it’s already given a couple of times over the last three months.

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