This Sector Could Surprise Investors in 2018
At the beginning of the year, analysts are aggressively sharing their best ideas. This is an annual ritual and Barron’s is one of the leading publications for printing the best ideas of analysts at the largest firms. For 2018, we’ve already seen a number of these articles.
Among the most recent is one titled, Year of the Bank: Citi, JPMorgan to Thrive in 2018. In this article, its analysts from Barclays sharing their work.
According to the article, their bullish outlook “isn’t due to anything new and sensational, just the double catalysts of lower corporate taxes and higher interest rates that has been building of late, but that there’s still plenty of upside ahead.”
Earnings growth is now expected to be close to 25% as the banks benefit from those factors. Yet valuations are low and dividends offer some down side protection.
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Value and Growth in a Money Center Bank
Citigroup Inc. (NYSE: C) is trading with a price to earnings (P/E) ratio of about 14.6 and offers share holders a dividend yield of about 1.7%. The Barclays report notes that Citigroup stands out among the big banks.
However, Citi’s stock price has stalled. This can be seen in the weekly chart which is shown below.
The daily chart shows that prices have not advanced significantly since October.
But, The Gains May Not Be Immediate
One reason the advance may have stalled is noted in the Barclays report. There are risks associated with the sector and with Citigroup. As the article explained, “Of course, nothing’s perfect, and there are a few concerns to note:
Our concerns center around several themes including: the economic outlook (banks are a reflection of the economy and we are in the later stages), interest rates (the yield curve is the flattest it’s been in over a decade, while deposit betas are on the rise and the Fed is unwinding QE), tax reform (while generally a positive, there are many moving pieces), and technology (moving very rapidly and competition remains intense, increasing the importance of economies of scale).
In addition, the pace and scale of regulatory rollback could be uneven (and MiFID II is a new uncertainty), while the mid-term elections will be of interest.”
MiFID is a set of new rules in Europe governing the sector that were implemented on January 1. These rules are far reaching and as of yet, not very well understood by analysts. This indicates it will probably take time for traders to become comfortable with the idea of owning companies affected by the rules.
Another potential concern is taxes. Many investment banks have announced that they will benefit in the long run but will be taking large charges in the short run. That means it could be months before the impact of tax reform is fully understood.
A Strategy to Benefit From The Wait for More Details
As we wait for clarity on the impact of MiFID and tax reform, we could see stocks settle into a trading range. This is true even for companies with bullish outlooks. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Citi
For Citi, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, February 9.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $1.41 in income ($0.39 from the call and $1.02 from the put). Buying the options will cost $1.11 ($0.32 for the call and $0.79 for the put). This means opening the trade will result in a credit of $0.30, or $30 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.30). This is equal to $0.70, or $70 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $70 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.30 or $30 per contract.
The potential reward on the trade ($30) is about 40% of the amount risked, a high potential return on investment for a trade that will be open for about one month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.