After getting over the shock of Trump winning the 2016 U.S. elections, Wall Street embraced the idea of eliminating much of the red tape in the financial sector, so banks can pursue their business with fewer restrictions. Consequently, traders piled in banks stocks in a big way.
At its highest in 2017, the Financial Select Sector SPDR Fund (NYSEARCA:XLF) had rallied 30% from last November. It has since given back some in a recent 6% dip that started on Aug. 8. Today, I want to catch the proverbial XLF falling knife.
The top six of its components make up about half of the XLF ETF. These are quality names like Bank of America Corp (NYSE:BAC), JPMorgan Chase & Co. (NYSE:JPM), Goldman Sachs Group Inc (NYSE:GS) and Berkshire Hathaway Inc. (NYSE:BRK.B). Fundamentally, they are the cream of the crop with reasonable valuations. They sell at PEs in the low teens and most pretty close to book value.
Furthermore, banks recently passed stress tests confirming that they are fortresses, and they were cleared to do a lot of financial engineering. These are buybacks and dividends which will support their stock prices.
Without a major change in the macroeconomics, the XLF ETF should remain a great value here. And therein lies my opportunity. Today, I will use this inherent value to generate income out of thin air. Critical to my strategy is that I am willing to own XLF shares if it continues to fall and breaches my support.
Click to Enlarge So without a major change in the macroeconomics the XLF should remain a great value here. And therein lies my opportunity. Today, I will use this inherent value to generate income out of thin air. Critical to my strategy is that I am willing to own XLF shares if it continues to fall and breaches my support.
It is important to note that I am not chasing prices higher. I don’t need a rally to profit like I would if I buy the XLF now. A big part of the reason bank stocks are falling is that treasuries are running wild.
Bonds are in the middle of a monstrous rally. This means that rates are falling fast. Traders equate falling rates with fewer profits for banks, which creates downside pressure on the XLF.
Bond experts have been bearish on bonds and wrong for years. So I want to respect this rally in treasuries. So I have to leave room for error. Technically, the XLF needs a bounce soon otherwise it falls into the clutches of the band that has been in contention since last December. Even though I expect its lower limits to hold as support long positions that don’t have a buffer will come under fire.
The Trade: Sell XLF Jan $21 put and collect 35 cents to open. Here I have an 85% theoretical odds that price will stay above my strike, so I can keep maximum gains. Otherwise, I own XLF shares and would accrue losses below $20.65. For those who don’t like to sell naked puts, they can sell spreads instead. There the risk is more finite.
The Alternate Trade: Sell Jan XLF Jan $22/$21 credit put spread which will yield 15% if successful. Since there are no guarantees when investing in the stock markets, I never bet 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 as @racernic on twitter and stocktwits.