Generally speaking, traders’ short-term reactions to earnings are more gambling than investing. First we don’t know the numbers that companies will deliver. Then we don’t know how Wall Street will react to those numbers. Today Bank of America Corp (NYSE:BAC) reported earnings, and the stock is down 1.6%.
The comments from Goldman Sachs Group Inc’s (NYSE:GS) conference call caused a second wave of selling. Both banks had shrugged the initial dip before those comments came out.
Traders’ expectations may have been lofty going into the earnings, so a few red days won’t spook me. Indeed most analyst ratings were outperform on BAC stock, so it’s not surprising to see a few letdowns today.
It’s also important to note that last week, JPMorgan Chase & Co. (NYSE:JPM) and Citigroup Inc (NYSE:C) earnings reactions set a negative tone coming into this week’s set of earnings. Markets sold those two stocks down on decent news on Friday.
Nevertheless, today’s price action doesn’t change the overall macro on banks. They recently told us that they will be defending their own stocks with financial engineering. So BAC is likely to buy back more stock on dips. The dividend will also lend tremendous support especially if the equity markets in general maintain their upward momentum.
I am long Bank of America stock, and this dip on the headline does not scare me. Mind you, my trading styles allows room for error, and that is why I prefer sell risk in BAC options rather than owning the equity. This way, dips like these don’t even register on my bad-trade-meter.
Fundamentally, BofA is incredibly cheap even after this massive rally. After today’s dip, the stock remains over 60% higher than 12 months ago and that doesn’t mean that it has gone too far yet. Its price-to-earnings ratio is 14 and its price-to-book is 1. So it cannot be a mistake owning the shares here let alone at my risk levels, which are much lower still. As long as the overall equity macro remains relative unscathed then BAC dips will be bought or, in my case, used to generate income.
Technically, BAC stock broke out from around $23.30 into this higher tiered level. It failed and now is on its way back to revisit the springboard level. There, bulls and bears are likely to fight it out hard, which should create a temporary stalemate. While I don’t expect it to be a hard line in the sand, I can count on it to be a rubber-band support zone to slow the selling down.
Click to Enlarge So today I will rinse and repeat prior winning trades of selling puts for income into BAC options. I don’t want to make it too tight in time, so I don’t have to be in the trenches while the bulls and the bears fight this support zone out. So I will step out a little farther and lower where I can sell puts for income.
An important element to this strategy is the fact that I am willing and able to own the shares at the level where I sell my puts. If the price falls below my strike then I must own the shares there and accrue losses below it.
If I am not willing to take that chance then I should sell a credit put spread instead. There my risk would be limited to the width of the spread less what I collect to open. Then the worst-case scenario would be more finite and carry less absolute risk in dollar terms.
This may seem like an aggressive way to trade a stock, but not if I believe its value. For the long term, I don’t mind temporarily owning Bank of America shares, so I am confident selling downside risk from here.
BAC Stock Trade Idea
The Bet: Sell the BAC Nov $22 put and collect 65 cents to open. Here I have an 80% theoretical chance of success but with earnings looming, the level matters more than the odds of success. Meaning I could find myself owning the shares, so I better be confident that it will be a good value there. I would accrue losses below $21.35.
To limit the downside risk I could use a bull put spread instead.
The Safer Bet: Sell the BAC $22/$21 credit put spread where I have less money on the line yet still yield 30% on my risk.
There are no guarantees in investing, so I never expose my portfolio to potential wipe-out trades.
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 on Twitter at @racernic and stocktwits at @racernic.
