Financial stocks have had a huge rally since the 2016 U.S. elections. The Financial Select Sector SPDR Fund (NYSEARCA:XLF) is up 30% in 12 months. The trigger for the spike was the election of President Donald Trump who vowed to unshackle banks from red tape. But the underlying thesis also includes other macroeconomic positives.
The Federal Reserve is undergoing a rate hike cycle and will further tighten money supply by selling back some of the assets that it amassed during its quantitative easing (QE) programs. These should create an environment that is conducive for banks to improve their profit-and-loss statements.
Fundamentally, Bank of America Corp (NYSE:BAC) stock is not expensive. It sells under a trailing price-earnings ratio of 15 and on par with book value. It also pays a dividend to boot, so it’s not a mistake to buy it at a discount.
But perhaps most importantly is the fact that banks passed a recent Fed stress test so they are flush with cash. Consequently, they were cleared to proceed with financial engineering.
Indeed, they promised to do more buybacks and dividends so it will be challenging to short their stocks. So all things equal, the upside trajectory in BAC stock should be easier than the downside.
This is not to say that they won’t correct from time to time, but it does place a solid floor below support levels. And therein lies my opportunity. I want to bet on the fact that the downside in BofA is limited.
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Technically, the BAC stock price rallied 8% in three weeks so it’s hard to bet long without worrying about being too late to this party. The $24 per share area has been pivotal all year.
It has served as resistance but also as support. And BAC is hinting that it will use the pivot zone as forward support. This is a thesis I can monetize but with room to spare.
In the absence of sustained dips, and given that BAC stock has rallied so much already, instead of buying the stock outright hoping for a rally in order to profit, I want to bet on proven support. I can sell downside risk to create income out of thin air.
But I leave some room for error and I can only do this by using options. Anything below $24 has a decent chance at holding if and when corrections happen.
Expectations are important to the success of a stock. In this case, analysts are reasonable with what they expect from BAC stock. But most rate it as a “buy.” It’s now trading within 6% of the average price target. This leaves some room for upside potential and could even spur a few price target upgrades if it continues to rally.
What’s important is that I don’t even need a rally to profit. Today’s setup will make me a winner even if Bank of America shares give back 10%.
The Bet: Sell BAC Jan 2018 $22 naked put and collect 50 cents. This is a bullish trade where I have an 80% theoretical chance of success. But if the BAC stock price falls below my strike then I have to own the shares and suffer losses below $21.50.
For those who want to mitigate risk, they can sell spreads instead. There the maximum is much smaller.
The Alternate Bet: Sell BAC Jan $22/$20 credit put spread where I have about the same odds of winning and where the spread would deliver 17% in yield.
Investing in stocks is risky, so I never bet more than I can afford to lose.
Learn how to generate income from options here. 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. You can follow him as @racernic on twitter and stocktwits.
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