The rally in Bank of America Corp (NYSE:BAC) has been impressive. So much so that the temptation to short BAC stock is too great to pass up.
Consensus on Wall Street is that banks under a Trump presidency should flourish to even higher highs. Add to it the fact that we are in a Federal Reserve rate hike cycle and you have a foolproof investment thesis. Therein lies the conundrum.
I get the bullish logic, but I lack the faith. I don’t think that there will be a switch that flips in January suddenly giving bank stocks the floor lost in 2008. BAC stock is now just below the level that was the trap door during the financial debacle that crippled the globe.
Last week, BAC reported a decent quarter, but Wall Street yawned with a mild upside poke. JPMorgan Chase & Co. (NYSE:JPM) also reported, and it clobbered expectations, yet JPM stock barely budged. Usually, when a stock or a sector can’t rally on great news then the bulls may be tired. This week’s reports are not starting well either, with Morgan Stanley (NYSE:MS) falling on another beat performance.
That’s why I’m banking (pun intended) that the sector will be pressured from lackluster reactions to earnings reports from MS or Goldman Sachs Group Inc (NYSE:GS).
Technically, this would be BAC’s sixth major bout with this price level. Twenty years ago, BAC stock broke out from $24 per share. In the following ten years, bulls successfully defended it twice, so it served as support. In 2008, $24 was lost and it’s not until now that BAC stock is this near to it again.
Every great champion needs to rest. So I will make a small bet that BAC stock may not get the oomph it needs to power through $24 per share. Luckily, the options markets allow me to structure trades with small risks to capture the slip.
The Bet: Buy the BAC March $23/$22 debit put spread. This is a bearish trade for which I pay 40 cents to open. This is my maximum potential risk. I stand to double my money if BAC stock falls through my spread.
Usually I like to hedge my bet by lowering my out-of-pocket expense. Although I think BAC could use a breather, I do not think BAC shares are in for a crash. In fact, the logic behind the outperformance of the banking sector makes sense. So I will use that thesis as the wind in my hedge sails. In this case, I will use the Financial Select Sector SPDR Fund (NYSEARCA:XLF) options to generate premium.
The Hedge (optional): Sell the XLF June $21/$20 credit put spread. This is a bullish trade for which I collect 16 cents per contract. This trade has an 85% theoretical chance of success and can yield 15% on money risked. I will likely delay entry into the hedge depending on the week’s price action from Bank of America stock. I won’t deploy it on falling prices.
By taking both trades, I need BAC stock to fall by March so I can double my money. But I also need the XLF to hold higher than $21, so I can collect the maximum profit from my hedge.
I do have to acknowledge that markets in general are at all-time high levels and this trade depends on a certain amount of broad stability. I am not required to hold these trades into expiration. I can close either at any time for partial gains or losses
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.