Daily Call Sheet Focus: Bank of America

Nov. 4.11 | About: Bank of (BAC)

By Mark D Bern, CPA CFA

This is the first of what I hope will be a daily series of articles to help equity owners of widely-held companies develop a strategy to enhance their returns and add some income to their portfolios. There will be two parts to each article:

  1. The first part will include an abbreviated analysis of a widely-held stock with an opinion as to whether I believe the stock represents a good long-term value relative to alternatives within its industry. Today’s selection is Bank of America (NYSE:BAC).
  2. The second part of the article will be a list of call options for widely-held stocks that, in my opinion, provide an adequate premium that current owners of the stock may consider selling for additional income.

An explanation of how that works is included later in the body of this article. All widely-held stocks may not be listed every day as there may not be any call option premiums that offer an adequate return to meet my minimum requirements. Some days the list will be long, on other days it will be short. I will list only the option for each stock that represents the best opportunity and meets my minimum requirements.

Today’s article will begin with an additional section explaining the strategy that uses call options to enhance income on long-term stock positions. Future articles in the series will not contain the explanation but will refer back to this initial article for details on the strategy.

Why Do We Sell Calls?

Historically, 83% of all options expire worthless. In other words, the buyers end up losing and the sellers make a profit 83% of the time. I like those odds better that being on the other side. We sell calls to collect a premium to enhance the return on a stock we already own. The stock does not need to pay a dividend; it just needs to have options trading on the stock in sufficient volume to provide adequate liquidity.

Each investor should have a goal (percentage) return that he/she tries to achieve each year from this strategy. My goal is to enhance my return so that I receive a minimum of 8% in cash each year from each stock that I hold, either from dividends, call premiums or a combination of both. Generally, that requires me to generate an average of about 5.5% from premiums each year, since my average dividend yield is 2.5% for my portfolio. Again, each investor needs to set suitable goals for themselves.

The goals can be higher or lower than mine. I reference my goals for illustration purposes only. I have found that investors usually tend to be (and for good reason) more conservative at first as they are learning how to employ the strategy and then raise their expectations as they become more familiar. Remember, 8% is my minimum, and that does not include appreciation.

I buy only stocks of companies that I want to hold for the long term. So, I’m not trading nor am I too concerned about the gyrations of the stock prices in the short term. As long as the fundamentals of the company and the industry it is in do not change I plan to hold on to the stock.

The other reason we sell calls is to make holding a stock less painful during broad market sell-offs. Selling calls can be profitable and seem easy on the way down, but the risk of having your stock called away on the way back up requires us to be more careful. I will say for now that there are years when the stock market is rising rapidly that I don’t consider selling calls. The strategy works best either when the market is falling or range-bound. I’ll get more into this a little later in the article.

Selling “Covered” Calls For Income

The concept is fairly straight forward but the application and execution can sometimes be a little more complex. The simple version of the explanation is that we are selling a call option which expires at some specific date in the future for a specific price, called the strike price. The seller of a call option is obligated to sell the underlying stock at the strike price. The buyer of the call option has the right (but not the obligation) to purchase the underlying stock at the strike price at any time prior to expiration.

The seller receives a premium (or the price the buyer is willing to pay for the option) which they keep regardless of whether the option is exercised or not. Options trade as contracts. Each contract represents 100 share of stock. So, when an investor sells one option contract they are agreeing to sell 100 shares of the underlying stock at a specified price on or before the expiration date.

It is important to note that most brokers do not allow an investor to sell naked calls. A naked call means that the investor does not own the underlying stock represented by the option contract. When we own the underlying stock the broker considers the trade to be “covered.” In other words, if the option is exercised we have the stock in the account to cover the shares to be sold.

Those are the basics. So, now let’s dig a little deeper into the details. As I mentioned above, it is better to sell calls when the market is either falling or trading within a range. Also, this same principal applies to the individual stock since all stocks do not necessarily move in concert with the market at all times. So, we need to pay attention to the trend of our stock and to the overall market.

We don’t have to be perfect and we don’t have to know when the market has topped or bottomed. Our objective is to ride with the trend and take a bigger piece out of the middle once the trend is established. As in all investing strategies, it is easier said than done. We will make mistakes occasionally. That is the nature of investing. But we will attempt to minimize the impact of our mistakes. That is one of the keys to successful investing.

When the overall stock market (I usually use the S&P 500 (NYSEARCA:SPY) as a proxy for the market) breaks out to new highs on fundamental strength such as rising earnings and a strong economy (right now we have one of those two going for us) selling calls may not be the best idea unless we consider long-term calls with expirations over one year away. Even then, there are instances, such as coming off the market low set in March 2009, when stocks were extremely undervalued and we should have expected a significant rise in valuations.

Selling calls would not have ended well during that period. By early summer of 2010 values seemed to have risen too far too fast and we were overdue for a correction. That was a good time to sell calls. From the early spring of 2011 to the recent October low selling calls worked well. Right now we are in a place where there are a lot of unknowns that could affect the global economy in either direction. I expect the market to move higher from here, but, because of the lingering uncertainties, we’ll continue to move sideways in a trading range. Although I expect the trading range to be higher than what we have experienced since August.

What I try to do is determine what the likely annual growth rate of a stock should be based upon. A company’s stock price and earnings don’t always move in tandem over the short term. Over the long term, there is a stronger correlation as expectations of future earnings are the primary force driving the price. But there are other factors that play into estimating the fair value of a stock and, by extension, the future stock price.

Obviously, the best measure is what someone is willing to pay. But that only helps us value the stock today in the current economic environment. There are several other factors in addition to earnings that we should consider when estimating what we believe the value of the stock will be at some future point in time.

One simple measure is the historical price/earnings ratio (PE) relative to the current PE. When we look at a stock from this point of view we must also consider the current earnings growth rate relative to the historical earnings growth rate of the company, the relative cost of capital (interest rate environment), the relative levels of company leverage, the relative levels of inflation and pricing flexibility, and the relative free cash flows as a percentage of revenue. Just looking at the PE alone doesn’t give a complete picture.

For example, if interest rates are falling, the cost of capital for a company in a heavily leveraged industry will decrease, resulting in rising profits and increasing free cash flows. This environment supports an expansion of PEs. Conversely, when interest rates are rising, the economic environment generally leads to PE contraction.

There are valuation models that can be used to estimate the fair market value (FMV) of a company (to derive the FMV per share simply divide the company FMV by the number of outstanding shares of common stock). Examples include the discounted cash flows approach, the business valuation approach, asset valuation approaches, earnings approaches (using the PE is one), and the variable growth dividend model.

The appropriate approach to use depends upon several factors including the type of business, whether the company pays a dividend, the capital intensity of the business, whether the industry is regulated, the importance of patents and the expected duration of existing patents, etc. I try to use what seems to fit the company and its industry. When considering a mature company with rising earnings and dividends I would probably choose the variable growth dividend model. If I’m valuing a growth company with a sustainable advantage such as patents, I might use the discounted cash flows approach.

That last paragraph probably takes us down a road we don’t need to follow further for this article. The point is that we should try to estimate what the company is really worth to determine if the stock price (market capitalization) represents a good value or if it is overpriced. A great company doesn’t always translate into a great investment (at least not in the short-to-intermediate term).

A short cut approach is to use a valuation provided in a research report from a source that you trust. The reason that his is important to this strategy is that we need to know when it is relatively safe to sell calls on a particular company. By relatively safe I am referring to a lower than average risk that the shares will be called away from us before the expiration date. In simple terms, we want to sell a call with a strike price that we don’t expect to be attained before the option expires.

So, if we have done our analysis and determine that the stock is fairly priced it should be fine to sell calls. If we feel that the stock is overpriced it is also fine to sell calls. If the stock is severely underpriced we should probably not sell calls. My goal of trying to get an 8% return (not including appreciation) doesn’t apply when the stock is appreciating faster than normal.

The question this brings us to is “What’s normal?” When the stock is fairly valued and we estimate that the average growth rate for earnings will be 6% per year, than normal is 6%. If we estimate that the same stock is undervalued by 10% than normal for the next year is something closer to 16%. If we estimate that the stock is over-valued by 10% than normal for the next year is probably closer to zero. Why is this important? We use this information to determine the strike price that limits the risk of having our stock called away from us.

If we estimate that the stock is fairly priced and growing earnings at an average annual pace of 6%, then we can feel that our risk is limited as long as the strike price we use is more than 6% above the current price with an exercise date of less than a year. This is how we estimate a target price for the stock over the next year.

Again, most investor find a reliable source for price targets to use for this purpose. For example, if your stock is currently priced at $45 and your reliable source has established a 12-month price target of $52, you can use that as your price target. The use of price targets is explained in the rules of thumb section below.

I’m sorry it took me so long to get to that point, but I wanted to try to answer as many questions with this article as possible so that I can refer back to it from future articles in the series. That way I can keep future article more concise and if readers follow my future articles they will only have to suffer this much detail once.

A Few Of My Rules Of Thumb:

  1. When the economy is recovering from recession or when the equities market is recovering from a correction, stock prices generally tend to rise faster than aggregate earnings. During these environments I tend to either not sell calls or use calls with much longer duration (LEAPs may have expiration dates over two years in the future) and with strike prices (plus premiums) at which I would be willing to sell the stock at any point before expiration. I will give an example when I get into the analysis of BAC.
  2. When the economy is slowing (not necessarily going into a recession) I will sell calls with shorter duration. Again, I only want to sell call options with strike prices at which I would be willing to sell the stock in case the price rises faster than expected. This means that the strike price includes a rise in price that is higher than my expected one-year target price for the stock.
  3. When the economy is in the later stages of a recovery and has made new highs (either after a recession or after a market correction) I will sell calls with expirations of up to a year at a strike price above my 12-month target price. I will also consider selling calls with expiration of up to two years using a 2-year price target price, if strike prices and good premiums can be found above that level. Once again, I must be willing to sell the stock at the strike price (plus the premium) if exercised.
  4. If my estimated value for the company is less than the current market capitalization (current stock price multiplied by the number of shares outstanding) by more than 10%, I tend to sell calls that expire in less than a year, but I am willing to consider any expiration date that offers the best expected return. I must be willing to sell the stock at the strike price (plus the premium).
  5. If my estimated value of the company is greater than the current market capitalization by more than 10%, I do not sell calls that expire in less than a year. I must be willing to sell the stock at the strike price (plus the premium).
  6. If my estimated value of the company is within 10% of the current market capitalization, I look for calls with strike prices that equal or exceed my estimated target price for the stock and expire in less than one year.

These are my rules. Every investor should consider what makes them comfortable and adopt rules that fit their needs. That may include a rule that says they will not consider selling calls under certain circumstances. In essence, I have included that in my rules by stating that I must be willing to accept the strike price (plus premium) if the option I sell is exercised.

I include the premium because it may represent a significant portion of my overall return. For example, if the strike price for a call that expires in January 2012 is $85 and the premium is $8.50, the premium represents an additional 10% over the selling price if the option is exercised. When calculating the total return on an investment, I include the dividends paid during the holding period. This is basically the same concept.

There is one last item that I need to explain before moving to BAC. Generally, when an investor buys a call option they do not want to buy the stock, especially the short-term options. We are selling out-of-the money options. The strike price we agree to sell at is higher than the current price. If an investor wanted to own the stock in the next three month, normally they would buy it at the current price now rather than pay a premium for the right to purchase the stock at a higher price three months from now.

These investors are expecting a significant short-term rise in the price of the stock that would result in the premium on the option rising also. The investor who buys the option has limited his/her risk to the premium paid while gaining significant leverage. Normally, if the price rises the buyer of the call will sell the call for a higher premium prior to expiration and pocket the difference. Those buyers of call option who are interested in obtaining the stock at the higher price are usually momentum investors who want to own a stock when it breaks through overhead resistance.

That is why you will see large numbers of open interest on certain strike prices. This is not to say that your option will expire if the price of the underlying stock exceeds the strike price. That is not the case. In that situation, the premium should equal the amount by which the stock price exceeds the strike price on the day of expiration. It also means that the option will probably be exercised unless you buy back the option before expiration.

If you want to hold your stock in this situation, you must buy back the option before expiration. You may have a small gain or a loss on the option. But if you are not willing to accept the strike price and sell your stock, but the option back. There, I said it three times so I hope that it is clear. Now let’s move on to Bank of America and a brief analysis of the company.

Since this is a bank stock it is much more difficult to value compared to companies in other industries due to the lack of transparency that is the rule in this industry. That being the case, I will use the simple method of valuing the company.

I start with expected forward earnings for fiscal year 2012. The consensus is $1.01 from 30 analysts that cover the company. The high estimate is $1.65 per share while the lowest estimate is $0.54 per share. My sense is that the low estimate is more pessimistic than warranted and has included a significant asset write down on foreign sovereign debt as well as the associated collateralized Debt Swaps (CDS) in place to offset those holdings. I don’t think that the write downs will be that drastic for BAC, at least not all in 2012.

I also believe that the low estimate has included a more dire outlook for the residential mortgage business than is warranted. I think BAC has most of that issue under control. I do think that there will be additional write downs in this area, but am not quite that pessimistic. Plus, BAC is likely to spread the losses out over several years as is the common practice in the industry, so 2012 should not be nearly as bad as the last three years in that area.

On the other hand, it seems that to get to the highest estimate that the assumptions are far too rosy. It would seem that not even the anticipated loss of $475 million in quarterly debit card revenues has been considered. I think that the consensus has this number included as well as most of the potential losses from the mortgage business, but it seems that there really isn’t much attention paid to the sovereign debt issue.

After adjustments, I come up with $0.90 per share and an average price-to-earnings ratio of nine. The historic average P/E is 11, but I don’t think that with all the turmoil and slow growth environment that 2012 can be considered normal. Once the eurozone is stabilized and the global economy gets back on its feet, we could see the P/E return to the average.

Until then, the volatility, weak economy, and the overhang from the sovereign debt situation warrant a P/E of only nine, in my opinion. That results in a one-year target price of $8.10. Of course, if the eurozone sovereign debt issues get out of hand and we see more than Greece defaulting in 2012 all bets are off. If I owned the stock and wanted to sell calls against it, I would need to be willing to sell the stock at that price in order to use it as my target.

I do not own BAC, but if I did I would consider selling the February 2012 $8.00 strike call with a premium (at the market close on November 3, 2011) $0.47. That provides a yield of 5.5% over 3.5 months or an annualized return of 18.9%. If I were to have the stock called away through exercise, I would be locking in a gain of 22.6% ($8 strike price received plus $0.47 premium received less the current price and then divided by the current price or [$8.47 - $6.91 = $1.56 then $1.56/$6.91 = 22.6%]).

The volatility caused by uncertainty in this sector is driving the premiums higher than we would expect in a more stable economic environment. It may be time to take advantage of the opportunities presented while they last. But, as always, this is a decision that needs to be made by each individual investor based upon his or her goals and needs.

And Now The Final Piece Of The Article:

My favorite call premiums on widely held stocks as of the market close on November 3, 2011. These are not pure recommendations; rather this list is provided as a useful tool for those who sell calls to enhance their income from stocks that they own or plan to own in the near future. The list includes premiums that appear to present the best value of all widely held stocks for the day.

My list of widely held stocks includes those stocks that consistently trade over 10 million shares per day. I generally do not include stocks that are priced below $10, with one exception: BAC. I included BAC due to its size and position within its industry as well as the simple fact that it has more shares traded on an average day than any other large capitalization company.

I have also included calls that meet my criteria on stocks that I have written about in another series that was begun on September 21, 2011 with the inaugural article entitled “My Long-Term Investing for Income Strategy”, click here to read the article.

The list may include up to 20 selections, but may be less if there are fewer premiums that provide a decent return. I hope readers will find this daily list useful as a starting place in finding calls to sell for added income.

Top 20 List



Exp Mo.

Strike $




$ 13.00

$ 0.73



$ 8.00

$ 0.47



$ 23.00

$ 1.25



$ 34.00

$ 1.89



$ 105.00

$ 4.05



$ 17.00

$ 1.15



$ 31.00

$ 1.20



$ 16.00

$ 1.01



$ 26.00

$ 1.15



$ 41.00

$ 2.11



$ 30.00

$ 1.99



$ 37.50

$ 1.21



$ 24.00

$ 1.90



$ 29.00

$ 1.02



$ 18.00

$ 1.06



$ 14.00

$ 0.65



$ 85.00

$ 4.89



$ 28.00

$ 0.93



$ 28.00

$ 0.88



$ 17.00

$ 0.59

Click to enlarge

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