Consider Bank of America Covered Calls

A new covered calls position was established yesterday in the Covered Calls Advisor Portfolio (CCAP) with the purchase of Bank of America (BAC) covered calls.

This advisor has had Bank of America on my watchlist for a couple of months with a 'buy' target if the price descended to below $10, which occurred yesterday. The recent precipitous decline in the prices of all major bank stocks continues. News late Wednesday that BofA was seeking additional capital from the Federal government sent the stock down another 20+% in Thursday morning's trading. With the implied volatility of the call options spiking to above 190, while the one-month historic volatility of the stock was a substantially lower 76, I have the sense that fear and panic were firmly established and that in hindsight this could be a capitulation moment.

I thought about Warren Buffett's maxim regarding the courage to buy in times of maximum fear. I also thought about a recent interview I saw in which bond maven Bill Gross talked about investing in areas where the Federal government is investing. Being a Washington observer, I believe the Feds will invest in BofA with additional capital from the TARP (Troubled Assets Recovery Program) and other guarantees sufficient to facilitate its acquisition of Merrill Lynch and in support of its ongoing business model.

The extent of BofA's losses and writedowns for the 4th quarter as well as the extent to which it will further reduce or eliminate its dividend remain as two of the many yet unanswered questions until its earnings are released next Tuesday. But with the panic yesterday, this advisor feels there is now adequate opportunity to benefit significantly by selling one-month in-the-money covered calls. As shown below, this high-risk but potentially very high-reward strategy has the potential for a 200+% annualized return-on-investment while providing 26.2% downside breakeven protection. Is the risk worth the potential reward? As always, time will tell.

Established Bank of America Corp Covered Calls for Feb09:
01/15/09 Bought 500 BAC @ $7.929
01/15/09 Sold 5 BAC Feb09 $7.50 Calls @ $2.08

Absolute Return if Exercised: +20.8%
Annualized Return If Exercised (ARIE): +204.6%
Downside Breakeven Protection: 26.2%

Disclosure: Long.

Comments

[jackooo:]

I seldom say excellent but this article is EXCELLENT!!
Anything the government backs up with cash is a winner.

Jan 16 01:52 PM

[Urbane Gori...:]

Just a thought... But if the government has to back them up, not once, but twice, (and according to Meredith Whitney... again in the future...) I'm not sure how that qualifies as being a winner.

But I did like the article. I don;t think I'd work this deal though. I suspect I'd end up eating the whole mess when BAC drops again. Still...

jegan

Jan 16 09:07 PM

[Big Al45:]

You may need all of that $2.08 downside protection and more. BAC is one more screw-up away from joining Citi in the under $5 dollar club.

Jan 16 09:32 PM

[TA:]

Buffett really meant buy 'quality' in times of fear which BAC unfortunately no longer is. That said there's a huge government backstop so it'll probably work out provided you call still resell ITM calls again in Feb.

I prefer to sell puts instead on quality companies since they are quite lucrative.

Jan 16 09:58 PM

[Steven Hansen:]

the problem with laying down bets right now is the percentage which will be a long term winner. the luckiest will do well. the unluckiest will lose. i think the toxic material inside the banks will come close to destroying them this year.

Jan 17 12:32 AM

[Conan the B...:]

"Anything the Government backs up with cash is a winner."

AIG, the Frannies, etc., anyone interested in buying GM currently? The potential for nationalization exists. They might survive but in what form and will shareholders see higher prices?

I agree with The Hand's assessment, all you have to do is to take a look at the value of the BKX as each pause in the vertical drop has only been a pause. This Index is now at lows not seen since 1995.

JPM is the only viable American bank in my opinion but even here I would be consider holding off until it drops below $20.

Jan 17 09:31 AM

[Fred Thomson:]

Keep in mind that it's impossible to tell the net worth of these large banks right now.

Mar 01 04:57 PM