Selling Bank of America Puts Is As Safe As It Gets

Aug. 9.07 | About: Bank of (BAC)

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 (NYSE: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.