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Investors looking to add a speculative investment to their portfolio should consider selling put options on the nation's largest banks. Our thesis is simple: The government will continue to provide assistance to the "Too Big To Fail Banks."

As banks such as National City, Wachovia and Washington Mutual were absorbed during the financial crisis, the asset and deposit base of the largest money center banks grew. We think that breaking up these banks is a politically tenuous process and would take years and significant coordination. As such, we believe the easier solution is for the U.S. to simply keep these banks alive and we believe that the Federal Reserve will keep interest rates low until the banks can earn their way out of the current predicament.

BAC is currently No. 2 on the list of the top 50 bank holding companies (by total assets).

  1. JP Morgan Chase (JPM) - $2,289,240,000
  2. Bank of America (BAC) - $2,221,386,576
  3. Citigroup (C) - $1,935,992,000
  4. Wells Fargo (WFC) - $1,304,945,000
  5. Goldman Sachs (GS) - $949,330,000

While these banks may be forced to sell assets or raise additional equity, we do not think that the government will allow them to fail, resulting in a wipe out of the equity.

Put Selling Strategy

Given our belief that the government will not let these large banks fail, we think that the best way to profit from their ultimate survival is to sell cash-secured puts on the stocks.

If you sell a put, you have an obligation to purchase the stock at a predetermined price (strike price) on or before the expiration date (if the buyer of the put option wants to sell you the stock). Clearly, the risk is that the stock drops significantly below the strike and you are forced to buy the stock at a price well above market.

Here are our two risk management rules of put selling:

  1. Only sell put options on stocks that you want to own at the price you want to own them - With a put selling income strategy (focused on out-of-the-money puts), you get paid to wait for the price you want on a stock. If the price never drops to your strike, you get to keep the premium (income) as a consolation prize. Your downside is owning the stock at the strike price (keep that in mind as you analyze the ideas below).
  2. Don't sell "naked" - Just because options offer you leverage, it doesn't mean that you have to use the leverage. We recommend securing your short put position with cash (i.e., don't sell on margin). If you aren't willing to risk the cash to back it up, don't sell the put!

Tactical Trades

Below are details of the option trades that we recommend for each stock. Since we view this as a long-term trade, we recommend selling a long-dated option (at least a year out). On average the trades below have a yield of 12.1% and a margin of safety of 32.7%, which we believe is a phenomenal risk/reward profile.

JP Morgan

  • Current Market Price: $35.73
  • Option: JPM Jan 2013 $28.00 Put (379 days to expiration)
  • Current Premium (bid): $2.73
  • Margin of Safety: 29.3%
  • Total Return (if option expires worthless): 10.8%

Bank of America

  • Current Market Price: $6.26
  • Option: BAC Jan 2013 $5.00 Put (379 days to expiration)
  • Current Premium (bid): $0.74
  • Margin of Safety: 31.9%
  • Total Return (if option expires worthless): 17.4%

Citigroup

  • Current Market Price: $29.03
  • Option: C Jan 2013 $20.00 Put (379 days to expiration)
  • Current Premium (bid): $2.39
  • Margin of Safety: 39.3%
  • Total Return (if option expires worthless): 13.6%

Wells Fargo

  • Current Market Price: $29.44
  • Option: WFC Jan 2013 $22.50 Put (424 days to expiration)
  • Current Premium (bid): $1.80
  • Margin of Safety: 29.7%
  • Total Return (if option expires worthless): 8.7%

Goldman Sachs

  • Current Market Price: $94.96
  • Option: GS Jan 2013 $70.00 Put (424 days to expiration)
  • Current Premium (bid): $6.40
  • Margin of Safety: 33.0%
  • Total Return (if option expires worthless): 10.1%
Source: 5 'Too Big To Fail' Banks To Bet On In 2012

Additional disclosure: Short BAC Jan 2013 $4.00 Put and C Jan 2013 $20.00 Put.