Options Action Monthly Trader Outlook

by CC July 25, 2011 11:45 am • Commentary

This is reposted from the Options Action Trader Outlook newsletter. If you would like to subscribe to the show’s emails go here.


Trader Outlook
Dan Nathan, Options Strategist, http://staging.riskreversal.com

Forget Buying “Best Of Breed”, Let’s Put Some Lipstick on a Pig and Get Long BAC


There are investors, and there are traders. And if you fancy yourself in the latter camp, now might be the time to hold you nose, and buy some stinky stocks. And that leads us to the banks, and Bank of America in particular.

The XLF is down about 3% ytd vs. a 6.5% gain for the SPX. While the relative performance isn’t great, when you drill down on some of the larger components of the index, a more complex story emerges. JPM and WFC, which comprise almost 18% of the index, have posted respective ytd losses of 1% and 5%. But when you look at the 5th through 7th largest weighted stocks, Citi, BAC, and GS ,which make up about 16% of the index, you see where the massive drag comes from. Those stocks are down anywhere from 15% to 24% this year.

So why BofA, and why now?

Well, perhaps it’s a case of being so bad, it’s actually good. The stock is one of the worst performing names in the S&P 500, let alone the XLF. Sentiment in the investment community couldn’t be worse with the stock at multi-year lows. Large investors are obviously lightening up, and the Wall Street analyst community remains very mixed with 20 Buys and 18 Holds.

So is all the bad news finally in the name? No one can know for certain, but at staging.riskreversal.com, I like to take contrarian views, and I like to look to these sorts of situations.

In this instance, I want to look out to November and the upcoming Q2 13f filings. These filings should indicate which large holders have dramatically reduced their positions, and November will capture Q3 earnings that will hopefully show some sequential improvement and a road map for better revenue growth.

Rather than buying the stock at about $10.15, I want to look to a structure called a risk reversal (my coincidence that my site is staging.riskreversal.com). In this structure, I want to sell the Nov 9-strike put for $0.40 and buy the Nov 11-strike call for $0.50, resulting in a $0.10 debit. My break-even on the upside on Nov expiration is 11.10, up 10% and I would have unlimited gains above that level. Between $9 and $11, I lose the $0.10 premium that I paid. The worst case scenario is that the stock below $9 by expiration, and I have to get long the stock at $9.

I like this structure because it allows you to take advantage of the skew between the price of the downside puts and the price of the upside calls. A couple caveats: when you sell naked puts, there are margin implications, so this trade structure is not for those who don’t want to run the risk of being naked short puts.