Using a Put Spread to Play Concerns Over Bank of America

Aug.16.11 | About: Bank of (BAC)

Over the past 10 days, rumors have suggested that Bank of America (NYSE:BAC) is dangerously undercapitalized due to significant risk in its residential real estate business. While management has tried to assure the public market that the company is adequately capitalized, investors are considering ways to play all the recent news on the firm.

From an options point of view, the following put spread trade provides a solid risk vs. return opportunity:

Purchasing 1 of the January 5 puts for $0.49 and selling 2 of the January 2.5 puts for $0.08 each, leading to a spread cost of $0.33.

Breakdown:

In the money

This trade makes money if Bank of America closes next January 20th in between $0.33 and $4.67. If the stock goes to zero, the January 5 puts would be worth $5 and 2 of the January 2.5 puts would be worth $2.50 each, so the spread would be worth zero minus the $0.33 paid for it. There is not further downside since the stock cannot go under zero and as such losses are capped at $0.33.

The most money would be made if Bank of America closes next January 20 at $2.50. At that level, the January 5 put will be worth $2.50 and the January 2.5 puts will be worth zero - leading to a positive gain of $2.17 ($2.50 - $0.33).

Out of the money

The most money that can be lost on this spread is the $0.33 paid for it. So if Bank of America, which is now trading at $7.50, goes up to $20, $50, or $1,000, the trade still only loses the $0.33 that was originally paid for the trade.

Summary: The trade can make $2.17, while only risking $0.33, which is 6.5 times your money. It will make money if the stock closes anywhere between $0.33 and $4.67.

The reason I like this trade: I believe the stock market will trade lower and I remain concerned regarding the fundamentals of banks (in particular Bank of America), which are not making money on their trading desks, continue to deal with a weak housing market, and have undefined exposure to the European crisis. Given those reasons, a short position in Bank of America makes sense. This trade allows a defined measure of risk while providing a solid beneficial return depending on what occurs in the economy and for the name over the next several months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.