One of the Few On-Sale Sectors Could Make Traders 45%

In case we had forgotten it is the banks’ job to make money, they are hiking ATM and checking account fees to record levels to generate additional revenue. In fact, if you use an out-of-network ATM, your average fee will be $4.35 per transaction, a 5% increase over the past year, according to a new survey by Bankrate.com.

More fees, along with greater loan demand, strength in investment banking and cost-cutting, are expected to result in higher third-quarter profits at the nation’s largest banks. The top six are anticipated to show combined net income of $16.2 billion for the quarter, according to analysts tracked by Thomson Reuters, a 21% increase over Q3 2013.

Most banks are still trading well below their pre-financial-crisis levels, while the economy continues to strengthen. A good way to take advantage of this is with the Financial Select Sector SPDR ETF (NYSE: XLF).

While the broader stock market has regained all of its losses and made new high after new high this year, XLF has only achieved a halfway retracement from its 2007 highs to its 2009 lows. That leaves plenty of room for continued upside.

XLF broke out of its four-year trading range in early 2013, and this move above resistance at $18 targeted an $8 run to $26.

XLF Stock Chart

The $26 target is about 13% higher than recent prices, but traders who use a capital-preserving, stock substitution strategy could make 45% on a move to that level.

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One major advantage of using a long call option rather than buying a stock outright is putting up much less capital to control 100 shares — that’s the power of leverage. But with all of the potential strike and expiration combinations, choosing an option can be a daunting task.

You want to buy a high-probability option that has enough time to be right, so there are two rules traders should follow:

Rule One: Choose a call option with a delta of 70 or above.

An option’s strike price is the level at which the options buyer has the right to purchase the underlying stock or ETF without any obligation to do so. (In reality, you rarely convert the option into shares, but rather simply sell back the option you bought to exit the trade for a gain or loss.)  

It is important to buy options that pay off from a modest price move in the underlying stock or ETF rather than those that only make money on the infrequent price explosion. In-the-money options are more expensive, but they’re worth it, as your chances of success are mathematically superior to buying cheap, out-of-the-money options that rarely pay off.

The options Greek delta approximates the odds that an option will be in the money at expiration. It is a measurement of how well an option follows the movement in the underlying security. You can find an option’s delta using an options calculator, such as the one offered by the CBOE.

With XLF trading near $22.95 at the time of this writing, an in-the-money $18 strike call option currently has about $4.95 in real or intrinsic value. The remainder of the premium is the time value of the option. And this call option has a delta of about 95.

Rule Two: Buy more time until expiration than you may need — at least three to six months — for the trade to develop.

Time is an investor’s greatest asset when you have completely limited the exposure risks. Traders often do not buy enough time for the trade to achieve profitable results. Nothing is more frustrating than being right about a move only after the option has expired.

With these rules in mind, I recommend the XLF Jan 2016 18 Calls at $5.50 or less. 

XLF Call Option

A close below $18 in XLF on a weekly basis or the loss of half of the options premium would trigger an exit. If you do not use a stop, the maximum loss is still limited to the $550 or less paid per option contract. The upside, on the other hand, is unlimited. And the January 2016 options give the bull trend over a year and three months to develop.

This trade breaks even at $23.50 ($18 strike plus $5.50 options premium). That is less than $1 above XLF’s recent price. If shares hit the $26 target, then the call option would have $8 of intrinsic value and deliver a gain of 45%. 

Recommended Trade Setup:

— Buy XLF Jan 2016 18 Calls at $5.50 or less
— Set stop-loss at $2.75
— Set initial price target at $8 for a potential 45% gain in 15.5 months

Note: There’s another call option strategy that lets you earn $1,200 or more each month from the stocks you already own — by “renting” them out to other investors. To learn about this easy process, click here.