U.S. Markets close in 4 hrs 45 mins

3 Financial Stocks to Trade Into Earnings

Nicolas Chahine

Opinions on Wall Street with regards to equities are very bifurcated these days. Most investors fall into one of two categories. On the one side, there are those who expect the Federal Reserve to bring about new highs for the rest of the year and beyond. On the opposite side, the rest want to short stocks here because they expect a big correction. But both groups are nervous, so there is a complete lack of conviction on either side of this fence.

Somewhere in the middle lies my opinion. I see new highs continuing for as long as the status quo persists. We don’t need a rate cut or a deal in China for stocks to plow higher. All we need is for the negative headlines to abate. In that case, the ongoing trend of climbing the wall of worry will then continue.

Today I focus on three financials: JP Morgan (NYSE:JPM), Bank of America (NYSE:BAC) and Square (NYSE:SQ). Each harbors an opportunity for profit, but for different reasons.

InvestorPlace - Stock Market News, Stock Advice & Trading Tips

Clearly I favor the equity upside scenario. It has worked for investors this year, and unless something changes, it should continue to work. Plus, there are so many overall skeptics that I bet that there is an ample supply of short stops that still linger above current level. These will fuel breakouts from here.

So this year the bulls have had the upper hand in spite of a tremendous wall of worry. And this time, even the financials are up 19% year to date. These are usually laggards but this year they are up slightly more than the S&P 500. They’ve recently had a big burst on the news that they all passed their stress tests. The exuberance is over their financial engineering events.

So going into the earnings season, they have tailwinds. But the opportunity lies in whether they are ready to kill the idea that they cannot hold a rally. They have lacked respect on that front, and this is their chance to stifle that impression.

Not all financial stocks are created equal. Almost all of them have value, but some deserve more respect than other. Overall, owning the major money centers for the long term, even if the rallies fail, is not likely to be a financial disaster. The floor in them should be shallow.

This is not to say that there won’t be disappointment from the relative performance to the benchmarks. The risk is just more of an opportunity loss versus the actual equity at stake.

Now, on to today’s goal to examine three financial stocks that have mid-term upside potential. The earnings season makes for a perfect catalyst for that potential. But given the binary nature of the earnings reactions on any given quarter, these opportunities will be make-or-break moves.

Financial Stocks to Buy: JP Morgan Chase (JPM)

Financial Stocks to Buy: JP Morgan Chase (JPM)

Source: Shutterstock

Investors often refer to JPM as the cream of the crop, so if investors can’t bet on its stock then they should avoid all bank stocks. Fundamentally there is little need to argue for value or future prospects. It’s cheap, selling at a 12x trailing price-to-earnings ratio. The 1.6 times book value is slightly higher than idea but still not bloated.  This is also before noting the 2.8% dividend that it pays stock holders while they wait.

JP Morgan management is a proven team and they rarely give Wall Street specific reasons to sell JPM stock. The upside of the financial crisis is that we now have banking institutions that are bullet proof. They may lack pizzazz but they have fortress balance sheets. Recently JP Morgan got the nod to sharpen its capital return to share holders via buybacks and dividends.

In addition to the value below, JPM stock now also offers an opportunity above. Technically the stock is attempting to break out from a neckline around $115 then again at $117.40 per share. If the bulls can break through these they can overshoot higher and target $128 or higher.

Otherwise, the worst that could happen is that the attempt fizzles again and price will have to reset. JP stock has support at $110 through $107 below, so the bulls can remount the effort a bit later. This is a case where the opportunity above outweighs the risk below.

JPM reports earnings on July 16, so there is that binary element in this thesis. The short-term reaction to earnings is hard to guess, but eventually the fundamentals and the technicals that were in play will resume.

Bank of America (BAC)

Financial Stocks to Buy: Bank of America (BAC)

Source: Shutterstock

While BAC stock carries many of the same bullish arguments as JP Morgan,  it’s less exciting to trade. It, too, is cheap — even cheaper than JPM stock. It has a 10.9 trailing P/E and trades at 1.2 times book value. Bank of America management is also proven, as it survived the 2008 catastrophe even after the regulators shoved bad banks down its throat. BAC stock successfully digested them and now is a stronger institution than ever.

But I have not had good luck chasing the upside in this stock. I’ve had much better success selling puts against support levels to generate income without any out-of-pocket expense. So instead of buying BAC shares, I sell downside Jan $25 puts and collect 70 cents per contract to open the trade. Then I don’t even need a rally to profit. If BAC stock stays above my put this year then I win 100%. Else I own shares and could accumulate losses below $24.30 per share. So basically it’s like going long BAC stock with a 16% buffer zone.

It is important to note that I don’t sell naked puts unless I am willing and able to own the shares.

Technically BAC stock does have a similar neckline breakout opportunity as JP Morgan, but again, I can’t forget about my personal history with the stock. If the bulls can overcome the resistance around $29.50 to $30 per share, they can invite more buyers to continue this rally.

Bank of America reports earnings on July 17, so I expect fireworks around that date. The short-term reaction to the headline is usually binary, so this adds a bit of gambling flair to the trade. Make sure to keep sizing in check.

Square (SQ)

Finance stocks: Square (SQ)

Source: Shutterstock

The third stock I chose is not a money center and is on the opposite side of the value argument. Yes, it’s a financial stock but it is a transactor so it is part of financial technology stocks. It competes with Visa (NYSE:V), MasterCard (NYSE:MA) and PayPal (NASDAQ:PYPL). These transactors don’t have the stigma when it comes to momentum stock action. Case in point — most are near or at all-time highs.

The opportunity here comes from the fact that Square has recently been lagging its fintech brothers. That sets it up for a catch-up trade. There is no clear reason to why it deserve the relative underperformance. And since its valuation is now much more humble than when it was flying high, the downside risk is smaller than the upside opportunity.

This is evident on the chart. The daily clearly shows that SQ stock has a support zone around $66 per share. So even if the rally doesn’t materialize, bullish trades have limited downside and stop loss orders can minimize the damage.

Furthermore, financial centers report earnings starting next week. So going long SQ is a good place to ride any upside momentum resulting for the positive reactions to the Financial Select Sector SPDR Fund (NYSEARCA:XLF), without exposing the trade to much sympathy downside drag in case banks’ earnings reactions are bad.

The bank stocks have not had this much love in a long time from Wall Street, so this rally feels extended. In reality, their valuations and their financial performances warrant more respect than they get. But now with the help of financial engineering their stocks may be on a revenge rally here and one worth chasing.

Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. Join his live chat room free here.

More From InvestorPlace

The post 3 Financial Stocks to Trade Into Earnings appeared first on InvestorPlace.