BofAML Spots a Bargain Upside Bet on the U.S. Stock Market

(Bloomberg) -- For U.S. equity investors wary of a sell-off but loath to miss out on a stocks rally, Bank of America Merrill Lynch is pitching an options strategy known as a calendar risk reversal.

Relatively muted swings and a wide price gap between bullish and bearish options bets means it is attractive to sell a medium-term put on the S&P 500 Index and buy a shorter-dated call, strategists including Gonzalo Asis and Stefano Pascale wrote in a note Tuesday.

Such trades generally outperform if the underlying index breaks higher and they are cheaper than simply purchasing calls until any equity sell-off reaches about 5%, a rare occurrence, the strategists said. As of Tuesday morning, the entry point for their preferred trade was the most attractive in 18 years, they added.

“At today’s levels, we like calendar risk reversals for equity replacement to position for a breakout higher in U.S. equities while reducing exposure to moderate drawdowns,” they wrote. “It is clearly the preferred trade when the S&P is flat to mildly lower.”

U.S. stocks sold off and volatility rose Tuesday as the Democrat-controlled House opened a formal impeachment inquiry against President Donald Trump. S&P 500 futures were flat as of 9:01 a.m. New York time on Wednesday, and the Cboe Volatility Index slipped 0.2% to 17.01. While the House’s move added to a raft of investor concerns including trade tensions and disappointing economic data, by some measures implied volatility is above its realized counterpart.

The Bank of America team suggests investors look at selling three-month puts to buy a one-month call, and recommended closing the trade when the shorter-dated option expires. That fits with their bullish view on risk assets amid a myriad of headwinds and risks, they said.

“Our house view remains bullish risk assets, but an abundance of headwinds and risks are challenging a stronger move higher in U.S. equities,” they said. “Have your equity cake without ‘eating it’ if risks materialize.”

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To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Cormac Mullen, Ravil Shirodkar

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