Selling Bank of America Puts Is As Safe As It Gets 10 comments
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Manoj Bidnurkar submits: Currently with the financial stocks in turmoil due to the sub-prime fallout and true to the herd mentality of investors some of the best financial stocks have been beaten down. If you can go against the herd, you have a rare opportunity to make some money with very low risk by playing Bank of America (BAC) put options.
When investing in options, I look for a very high margin of safety. I try to get to a point, where my investment is "Heads you win, Tails you don't loose". Selling Bank of America put options fits the bill perfectly right now. If you buy PUT option, it gives you the right to sell a stock at a certain price, which is called the strike price. Selling a put option obligates you to buy the stock at the strike price of the option.
Due to the sub-prime fallout, BAC stock has taken a hit and has come down from almost $54 to $47 in a span of six months, when its business scenario has not changed at all. With market fear reaching high levels and panic having gripped most of the investors, BAC stock price is based on a tremendous amount of pessimism which is mostly unwarranted. Consequently, the option premiums on Out-of-Money put options for BAC have become really enticing.
Following is a trade I made a few days ago and I suspect I may get another opportunity to do the trade again in a few days / weeks. I sold JAN 2008 $40 BAC put contracts. Each contract controls 100 shares. Option premium I received was $1.30 per contract.
Lets say you sold 10 contracts. That earns you $1300 ($1.30 X 100 X 10) cash into your brokerage account right away. To sell these naked puts your broker will make you maintain a cash balance in your account.
Now, I will explain why this strategy is a real "Heads you win, Tails you don't loose" one. Following can be the outcomes of selling the above puts.
1. On January 18, 2008 (option expiry date), BAC stock price stays above $40: In that case, the puts expire worthless and you get to keep the $1300 you received by selling the puts. After that you no longer have to maintain the required cash balance in your account.
For my broker, the cash balance requirement right now for selling the PUT is about $600 for each contract. So for keeping a cash balance of $6000 ($600 X 10) for 164 days (8/7/2007 to 1/18/2008), you got a payment of $1300 . Thats a cool 48% annualized return!
Heads you win.
2. On January 18, 2008, BAC stock price is below $40: Your sold puts will get assigned and now you are obligated to buy 1000 shares at $40 each. Your cost basis for the shares will be $38.70 ($40 - $1.30 option premium).
Even though you will be forced to buy the shares here, I look at this as a great opportunity to own a blue chip. Here is why:
BAC currently pays out a dividend of $2.56 per share. At a cost basis of $38.70 a share, thats a yield of 6.6%. But wait, the story gets better: BAC has been raising the dividend every year by about 10%. So going forward, the dividend yield on your shares will keep on climbing. And it gets even better: BAC has been increasing earnings about 5 - 6% every year. With a 6.6% dividend and 6% earnings growth it gives you a 12% annual total return in the long run.
You get to buy a quality blue-chip at a bargain basement price. Tails you don't loose.
Warren Buffet's two simple rules of investing are: 1. Don't loose money 2. Don't forget Rule No. 1.
The selling puts strategy explained here, comes as close to that as you can. Heads you win, Tails you don't loose! When the odds are in our favor, cost of inaction is a lost opportunity cost. No wonder, I have been salivating at this selling puts strategy since the market started throwing the baby out with the bath water.
Disclosure: I am long on BAC shares and have also sold the JAN 2008 $40 PUT options.
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This article has 10 comments:
So if that stock is at $30, you're down on your BAC stock holding and are now assigned a stock you have to pay $40 less that $1.30 premium for. Also, you've had to put who knows how much cash into that brokerage account as the short put value has gone the other way on you. Don't forget the opportunity cost of that collateral/margin cash you need too, that just sits there in your account when you could have been investing it elsewhere.
I think selling puts is an ok at best idea using short dated options if you want a stock at a specific price. That way you have theta decay working for you at a more rapid pace. Most longer dated options under-price volatility and theta decay is nowhere near as pronounced which is why being a buyer as opposed to a writer is preferable for longer-dated options.
Bill Yates
impliedriskreport.blog...
I don't think you have fully thought out this trade and there are several scenarios where you can loose a lot of money. All you are doing here is making a leveraged bet on the stock NOT GOING DOWN till January. If it goes to 50 then you should be long a call or the stock. If it goes to 20 then you should sell the stock now or buy a put.
There is no free lunch on Wall Street.
In addition to what the other commenters said, there is no guarantee that BAC will continue to pay the same rate of dividend - let alone increase it by 10% annually.
If you don't think the stock is going down, you'd be better off buying it and collecting the dividend rather than a measly $1.30. Selling puts that are far away calendar-wise is a bad idea. If anything, sell nearer-term puts that are closer to being int he money. THAT at least makes sense. its' very dangerous to sell options that are so far away, because you never know how the company's situation will change by January, eg.
But...if you want to buy BAC for the LONG TERM, and you think it's a good VALUE to buy at $45 or lower, then one strategy is to sell the near-term 45's and collect the premium. If it stays above $45 you'll keep the premium - if not, you'll get the stock at $45, and your cost will be the $45 less the collected premium.
Bottom line: you're being too cute for a very small amount of money. There's no free lunch.
...Misspell 'lose.'
Just a pet peeve, I guess.
The <b>primary</b... goal of this strategy is to play the option. The <b>secondary<... goal which will be forced on you, is to buy a blue chip stock at bargain basement price.
<b>1. Cash Balance Requirements:</b>...
Amit Choksi is correct that if BAC stock moves down, the cash balance requirement will become higher. For sake of argument, lets say the Cash Balance requirement just quadrupled. So instead of $6000 now you have to hold $24000. Getting $1300 on this amount in 164 days gives you a 12% annualized return on the investment. Not bad. If you just take a tripling of the cash balance to $18000, you get a 18% return. Not bad at all.
<b>2. When to sell the puts:</b>
yate6460: You will never get the exact bottom. What you have to work out is with the current play does it give you a good return and safety.
<b>3. Al Rob</b> - Aren't we all betting on a stock going in a certain direction? Can BAC go to $20. Yes. What are the chances? Pretty negligible. Can a person get hit by a car while walking down the street? What are the chances?
<b>4. Dividends:</b>
slickvguy: BAC has raised their dividend by about 10% every year for the past 5 years. If you go back farther in the past, you will see the similar statistic. Is there a possibility that they may cut the dividend going forward? Yes. What are the chances? Pretty negligible. Is there a possibility that they stop increasing the dividend going forward? Yes. Chances? Pretty low.
5. Why not sell short term $45 PUTs:
slickvguy: In the current market scenario, in short term, BAC stock may trade lower. In that case if you have sold the short term $45 PUTs you will be obligated to buy the stock at $45 less the option premium. If you are willing to buy the stock at $45 less the option premium, then whats not to like about buying it at $40 less the option premium. And again, the primary goal is to play the option and make a good return. And not to buy the stock.
Also selling the JAN 2008 PUT gives the market a reasonable amount of time to correct and come out of the panic and for the stock price to head up or stop falling.
6. Last, the strategy clearly says that the unwanted outcome is you will end up buying BAC at $38.70. So if you don't think BAC is a bargain at that price, then don't play this strategy.
Your strategy is very very risky given how far dated the options you're short are. You have no hedge, if you're going to play the option and it seems you mean to imply you want some income as opposed to "playing it", set up a vertical or horizontal spread where you partially hedge your risk. Takign a quick look at the BAC options it seems you've gone to the Jan options because those are the only ones that have some "meat" to them which to me suggests there's even a bigger problem because you're short volatility. The option premiums for BAC look fairly low, so you're taking on more risk by going further out to get some fatter income but you're doing it at low volatility (relative to most options)
Everything you say regarding the probability of BAC falling/dividend cut may be true but you're dealing with a skewed return profile. If BAC is down to even $37 or $36 per share and you're assigned, you're paying $38.70 for a stock that is worth $37. If they're down to $35 or $30, you get the picture. And if you look at some of these megabanks back in the early 90s, these stocks has dropped into the teens.
Bank of America stock has rallied to around $52 today morning, from the lows of around $47 around August 9th. The strategy I had suggested of Selling Jan 40 PUTs for $1.30 each has paid rewards.
Today the PUTs are trading at $0.60. Today you can buy back the 10 contracts that you sold, for a total of $600. That gives you a profit of $700 in 14 days on your cash requirement of about $6000.
I have closed out my position, by buying back the PUTs that I had sold on August 9th.
The trade has yielded a 11.7% in two weeks. This is something in between "Heads I win, Tails I don't loose". Lets say the coin fell on its edge!