Cashing in on Financials
Over the past three months, the stock market has been an options trader’s paradise. Price movements that usually take years to occur have been happening in a matter of weeks. In a moment, I’ll show you one way to profit from this trend.
After closing below $223 on March 23, the SPDR S&P 500 ETF Trust (SPY) has rallied more than 36%. At the end of May, SPY was back above $300 and down less than 5% for the year.
That is a remarkable rebound given how bad the economic news has been lately. In April, unemployment rose to its highest level ever since being tracked 72 years ago. At the same time, consumer spending suffered its biggest decline ever recorded.
You may be thinking that it is too late to get in on the action. The good news is that it’s not too late. However, you will need to be smart about how you do it.
I don’t recommend betting on SPY to keep going up. That’s because the index is cap-weighted, so bigger stocks have more influence on its performance. With a market cap of $1.4 trillion, Apple (NSDQ: AAPL) has more than 10 times the weight of Amgen (NSDQ: AMGN) and its $131.8 billion market cap.
How big of a difference does that make? At the end of May, the Invesco S&P 500 Equal Weight ETF (RSP) was down 12.1% for the year, more than twice the loss in the cap-weighted SPY. That means a lot of stocks have performed considerably worse than the index.
Therein lays the opportunity for options traders. First, identify sectors within the index that have yet to fully participate in the rally. Second, buy call options on an exchange-traded fund (ETF) for that sector to profit from its recovery.
Follow the Money
A friend of mine recently shared a trade with me that he believes could double his money before the end of this year. Here is how it works.
A sector he believes that is likely to recover strongly during the second half of the years is financials. That makes sense. If the unemployment rate starts improving this month as the economy begins to open back up, then most financial stocks should benefit.
The fund he likes is the Financial Select Sector SPDR Fund (XLF). That is also a good choice. XLF has more than $17 billion in assets and is widely traded so liquidity is not a problem. At the end of May, it was down nearly 23.3% for the year. That is more than four times the decline in SPY.
His logic is sound. If the economy recovers quickly enough to justify the huge recovery in SPY over the past two months, financial stocks shouldn’t be far behind.
The trade he is making is a “bull call spread,” so named because he is being bullish by betting on the price of XLF to rise. Call options go up in value when the price of the underlying security increases. A spread trade means he is buying a call option at one strike price while selling another call option at a different strike price at the same time. Both options expire on the same date.
A few days ago, the $22 call option on XLF expiring on December 18 could be bought for $3.25. At the same time, the $28 call option expiring on the same day could be sold for $0.55. His net cost to make this trade is $2.70 ($3.25 – $0.55).
Know the Risks
The advantage of a bull call spread is that it offers huge upside potential while reducing the cost of placing the trade. If XLF rises to $28 before this option expires, the $22 call option will be worth $6. That gain is more than double the $2.70 cost of placing the trade.
The breakeven point is $24.70, which is the $22 strike price plus the net cost of placing the trade. To the extent XLF rises above that price prior to expiration, this trade will be profitable.
The downside risk is if XLF falls below $22 at expiration. In that case, this trade results in a complete loss.
There is another risk to this trade. If XLF rises above $28 before expiration, selling that option was a bad move. That’s because any gain above that price will benefit the person to whom that option was sold.
As you can see, you really need to know what you are doing to engage in this type of trading. If you do not, I suggest you follow the advice of my colleague, Amber Hestla.
Amber Hestla is the chief investment strategist of our premium trading service, Profit Amplifier. Amber has devised a highly unusual but powerful tactic that turns tiny price moves into massive gains.
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