The Recent Price Action Does Not Change The Bullish Outlook For Bank Of America

| About: Bank of (BAC)

Summary

BAC stock price keeps bouncing around the $22 - $24 level, not able to break out above its previous highs.

The main catalyst for BAC (increasing interest rates) stays in place.

The lack of price volatility results in underpriced call options on BAC.

In the last 3 months the stock price of BAC has been consolidating around the $22 - $24 level. In the beginning of 2017 the stock price was still continuing its uptrend, triggered by the presidential election of Donald Trump and the prospect of rising interest rates.

The stock price reached a high level at $25.8 earlier in March this year, followed by a pullback to the $22 price level.

Source: finviz.com

For those of you reading my previous articles on BAC will probably know I have been bullish on this stock since the beginning of the rally and as of today my opinion on BAC has not changed. The goal of this article is not to provide you with a detailed analysis on the fundamentals of BAC or the current macro-economic environment, but rather a high-level view on what has happened with the stock price and what kind of price action we can expect in the coming months/years.

Background

Since the presidential elections of November 2016, bank stocks have appreciated strongly. BAC has been the strongest price performer compared with its peers (Wells Fargo (NYSE:WFC), Citigroup (NYSE:C), JPMorgan (NYSE:JPM)).

Source: stockcharts.com

The main reasons behind the uptrend in BAC:

  • Increasing inflation numbers (as a result of the improving economy and planned US infrastructure investments)
  • Low valuation ratio's (P/E, P/B, ..)
  • Internal cost-cutting initiatives
  • Deregulation (Dodd-Frank legislation) by the Trump Administration.

The main reasons behind the current consolidation in the stock price of BAC (in my opinion):

  • Worries whether the Trump Administration will be able to implement the bullish actions points, like the deregulation of Dodd-Frank
  • Trend exhaustion: BAC has risen strongly in the previous months and investors are more reluctant to buy new shares of BAC as the stock price has become more expensive compared with its fundamentals. The stock was clearly undervalued around the 10$ - 15$ price level, but now at these new multi year high prices investors are more reluctant to step in.
  • The danger of slowing inflation and the impact on the rate hikes of the Federal Reserve

Taking into consideration the points above, I remain bullish on BAC. The main catalyst (increasing interest rates and the effect this will have on the earnings of BAC) still remains in place. The last earnings report of BAC confirmed the growth in interest income for Q1 2017.

I don't expect the Federal Reserve to stop increasing the interest rates in the near future, not as long as the inflation rate and the employment figures remain solid. Even if the Federal Reserve would skip one or two rate hikes, this will only have a limited impact on the earnings power of BAC.

Options Trade

As I wrote in my last article, I have been holding stocks of BAC which I had bought around the $10 price level. I sold my stocks once the stock price of BAC crossed over the $20 mark, doubling my initial investment. After I sold these shares, I regretted my decision, because I believed the fundamentals of BAC will drive the stock price up to higher levels in the coming months/years.

To participate in this investment opportunity, I bought call options on BAC expiring in January 2018 with an exercise price of $22. The main reasons for choosing call options over buying the common shares were:

  • An investment in call options requires only the purchase of the options, requiring a lower capital investment. By buying 10 call option contracts of BAC $22 calls, I only need to pay a fraction of what 1000 BAC common shares would cost.
  • The low implied volatility of the stock market holds the premium price of these option contracts low.
  • The leveraged ROI an investment in call options can offer compared with the ROI of an investment in common BAC stock

In my last article on BAC I posted the following table:

The main idea behind this table: If the stock price of BAC would retrace its previous high of 25$ (8.1% above the stock price on 24 March 2017), the call options would appreciate with 54.4% (see previous article for the details of this calculation).

As of today, BAC has not retraced the $25 high. The stock price is currently at $23.4 and the call price is at $2.55.

As you can see the stock price appreciated slightly in price (+1.3%) while the call premium price declined with almost 9%. This can be explained by the lifetime of the option contract, as the contracts come closer to their expiration date, the less time there is left for the stock price to appreciate.

All in all, I'm not disappointed with my investment in these call options. The expiration date is still months away from today, giving the stock price still the time to appreciate in value. Once the new quarterly earnings reports will be published in the coming months, I expect them to confirm the growth in net interest income for BAC, which will convince investors of the earnings power BAC has.

In conclusion: While the uptrend in BAC has been slowing down in the previous months, the stock still remains an attractive investment as long as we expect increasing interest rates. Given the current price level of BAC and the low implied volatility, I prefer call options over common shares. As explained earlier I would recommend to purchase stock options with a far out expiration date, giving the stock price sufficient time to appreciate.

Disclosure: I am/we are long BAC CALLS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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