High Income Opportunity From Citigroup
Trade summary: A bear call spread in Citigroup Inc. (NYSE:C) using November $40 call options for about $4.60 and buy a November $45 call for about $1.57. This trade generates a credit of $3.03, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $197. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($303). This trade offers a potential return of about 53% of the amount risked.
Now, let’s look at the details.
Barron’s reported that C reported earnings which were lower than last year’s third quarter but better than what analysts expected.
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The stock was weak on the news.
According to Barron’s, “The bank reported third-quarter revenue of $17.3 billion, just ahead of the $17.2 billion analysts surveyed by FactSet projected. Earnings per share of $1.40 topped analyst projections of 91 cents.
Citigroup benefited from signs of improving credit trends. It reported credit losses of $1.9 billion, down from $2.2 billion in the previous quarter and in line with last year’s third quarter. The bank also posted a significantly smaller allowance for credit losses in the third quarter, adding just $314 million to reserves, compared to $5.6 billion in the second quarter. Credit costs totaled $2.3 billion for the quarter, down from $7.9 billion in the previous quarter.
“We continue to navigate the effects of the Covid-19 pandemic extremely well. Credit costs have stabilized,” Michael Corbat, chief executive of Citigroup, said Tuesday.
Citigroup’s results come amid a tumultuous period for the bank. Last week it was fined $400 million by regulators for deficiencies in its risk management controls. Earlier this year, the bank said it was spending $1 billion to improve its infrastructure but acknowledged that there is still much progress to be made.
“We are committed to thoroughly addressing the issues contained in the Consent Orders we entered into last week with the Federal Reserve and the Office of the Comptroller of the Currency,” Corbat said.
Still, the bank fielded several questions from analysts about the impact of the consent order on the bank’s prospects. Analysts were concerned about extra expenses –outside of those already outlined — the bank could incur as it improves its controls.
The bank said its expenses increased by 5% to $11 billion in the third quarter, reflecting the $400 million fine, investments in infrastructure, increases in compensation, and Covid-19 expenses.”
The stock is now at support and additional weakness is possible.
To benefit from weakness, traders can sell shares short. Shorting shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for C
For C, we could sell a November $40 call for about $4.60 and buy a November $45 call for about $1.57. This trade generates a credit of $3.03, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $303. The credit received when the trade is opened, $303 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $197. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($303).
This trade offers a potential return of about 53% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if C is below $40 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $197 for this trade in C.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.