Fundamentally, banks in general are on solid footing. They told us as much when they all passed the stress test with flying colors. Technically, the Financial Select Sector SPDR Fund (NYSEARCA:XLF) is also showing the potential for another leg higher.
Bank of America Corp (NYSE:BAC) is a premier bank that suffered through tough tribulations after the financial crash and survived an onslaught of litigation, most fiercely from the U.S. Government. Luckily for all of us, it emerged a lean and mean financial institution that is ready to thrive.
I don’t like to chase prices, not even in a solid BAC stock. It’s not so much from concern over its valuation, but I am leery of allocating capital when markets are all-time highs without marked improvements in the macro environment.
So I do the next best thing, which is generate income out of thin air betting on the bullish price action here.
Click to Enlarge After the recent stress tests, banks collectively told us of their intentions of investing in their own stocks. This financial engineering is ideal support against which I can sell downside risk for income.
If my trade fails, then I must own BAC shares and could suffer losses for as long as it continues to fall. But even after a 70% 12-month rally, BAC is still at a price-earnings ratio of 15 and in line with its book value.
I say this to highlight why I am comfortable selling the puts. There is already value right here. So the worst-case scenario, I’d be owning a valuable stock and at a 10% discount to boot.
Although it is an opportunity to spike, technically, I see an area of difficulty above $24.80. But I also see a clear support zone below $22 where buyers of BAC have stepped in to buy it. Since the fundamentals have not deteriorated, then I will assume that the support will continue to hold through 2017. That’s about where I can set my risk today.
The Trade: Sell the BAC Dec $22 puts and collect 50 cents to open. This trade offers me a 85% theoretical odds of earnings maximum gains. However, I would need to own the shares at that price if it falls below my strike. Then I would accrue losses below $21.50.
Recently I did a similar trade and earned easy profits and today I am merely repeating another with profits in hand. Both trades have the same thesis, which is that I am willing to own BAC stock lower.
But for those who don’t want to own shares, I can mitigate the risk of selling naked puts I can sell a spread instead. There the maximum exposure is equal to the width of the spread less what I collect to open the trade.
The Alternate Trade: Sell BAC Dec $22/$21 credit put spread. This is also a bullish trade with the same chance of winning. If it wins the spread would deliver roughly 20% in yield.
Compare this with the traditional way of going long a stock, which is to risk $24.50 buying Bank of America here with no room for error. Even selling options is risky, however, so I never risk more than I am willing 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 on Twitter at @racernic and stocktwits at @racernic.
