It's usually good news when a company delivers quarterly results
that beat analysts' expectations, especially when they beat
onearnings andrevenue . That's exactly what
Wells Fargo (
did on Friday, Jan. 11, but thestock 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.
Traditionally, banks have earned profits by borrowingmoney at a
low interest rate and lending the money out at a higher interest
rate. Savings accounts or certificates ofdeposit (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 interestmargin and is an important indicator of a bank's
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 financialstocks . One of the best-performing
stocks in 2012,
Bank of America (
, 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 ProfitableTrading.com
colleague, Michael J. Carr,market
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 significantleverage 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
theoption . Contracts expiring months from nowwill have a higher
time premium and cost more than options expiring in days.
The $12put 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 theput , Bank of America would need to fall below
$11.40 ($12strike 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
theearnings 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 looksovervalued 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 thePEG
(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 befair 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 toprofit 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 12Puts 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
This article originally appeared on ProfitableTrading.com:
This Trade Could Make You 40% by Friday's