This Trade Could Make You 40% If You Act Now

It’s usually good news when a company delivers quarterly results that beat analysts’ expectations, especially when they beat on earnings and revenue. That’s exactly what Wells Fargo (NYSE: WFC) did on Friday, Jan. 11, but the stock sold off and that sell-off continued into Monday, Jan. 14. Buried in the report was a warning sign that the future might not be as good for banks as the recent past has been.#-ad_banner-#

Traditionally, banks have earned profits by borrowing money at a low interest rate and lending the money out at a higher interest rate. Savings accounts or certificates of deposit (CDs) are an example of how banks borrow money from depositors. The rates they pay on these accounts are usually very low. They lend money through mortgages or car loans at higher rates. The difference between their borrowing costs and what borrowers pay for loans is known as the net interest margin and is an important indicator of a bank’s profitability.

Wells Fargo reported that its net interest margin fell to 3.56% in the fourth quarter of 2012. This is down from 3.89% in the fourth quarter of 2011, and is also down slightly from the third quarter of 2012. With the Federal Reserve doing its best to push down interest rates on mortgages and other consumer loans, the outlook for Wells Fargo troubled investors and the stock fell almost 2% in the two days after it announced its earnings.

Operating results and the subsequent sell-off in the stock could be a bad sign for financial stocks. One of the best-performing stocks in 2012, Bank of America (NYSE: BAC), reports earnings before the open on Thursday.

Bank of America had a net interest margin of 3.43% last quarter and a further decline could scare traders. My colleague, Michael J. Carr, pointed out in this week’s market outlook that the stock has dropped an average of about 1.7% on the day earnings are released.

Trading gains from a small move like that could be magnified with options that allow traders to obtain significant leverage on their trading capital. January options expire on Friday and have only a small amount of time premium remaining. Options prices always include a time premium based on how much life is left in the option. Contracts expiring months from now will have a higher time premium and cost more than options expiring in days.

The $12 put option that expires when trading ends on Friday is priced at about 60 cents with Bank of America stock at $11.47. To breakeven on the put, Bank of America would need to fall below $11.40 ($12 strike price minus the 60 cents premium). That breakeven point is only 0.6% away and the stock has declined more than that, on average, when it announces earnings.

Bank of America is likely to report a downward trend in its interest rate margin just like Wells Fargo did last week. The result in the market is likely to be similar with downward pressure on the stock price. If Bank of America stock trades down 1.7% on the earnings announcement, it could fall below $11.27 and the option would be worth at least 73 cents, a potential gain of about 22% in less than a week. Based on the chart, I expect BAC to fall to $11 where it should find short-term support, which makes the potential gain on the put option more than 66%.

After gaining about 80% in the past 12-months, Bank of America stock looks overvalued by many measures. The price-to-earnings (P/E) ratio is about 12 times next year’s earnings and earnings growth is expected to be near 10% a year. That makes the PEG (price/earnings to growth) ratio, a comparison of the P/E ratio to the earnings growth rate, about 1.2. This is about 20% more than the ideal value of 1 that many analysts consider to be fair value in the PEG ratio.

Research firm Thompson Reuters rated Bank of America as one of the big-cap stocks most likely to miss its estimates this quarter. This options trade is a cheap way to profit if that forecast is correct. If Bank of America disappoints analysts this week, then traders are likely to sell the stock and lock in any gains they may have in the company.

Action to Take –> Buy BAC Jan 12 Puts at 70 cents or less. Set stop-loss at 50 cents. Set profit target at $1 for a potential 43% gain in less than a week.

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This Trade Could Make You 40% by Friday’s Close

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