Range Bound Financials Provide Option Opportunities

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 |  Includes: BAC, C, GS, JPM, MS
by: Bill Maurer

I recently argued that this market has no direction. A combination of bad US jobs and economic data is usually offset by the hopes of more Quantitative Easing from the Federal Reserve. When things in Europe get worse, the promise of more stimulus brings us back. Altogether, the market can't seem to sustain a move in either direction, which sticks us in a range for an extended period of time.

But a range bound market can provide opportunities. Today I'm going to discuss opportunities in the financial sector, primarily in some of the large cap banks. For mainly the reasons I listed above, I don't see many of the big names making any large moves over the next couple of months. Lately, when banks get low enough, stimulus or QE3 rumors have brought them back up. Then when they are rallying, we get news like the JP Morgan (JPM) bad trade or the Barclays (BCS) LIBOR scandal that knock them down. We also saw Morgan Stanley (MS) shares decline after the Facebook (FB) IPO fiasco.

For those reasons, I'm going to recommend some options trades, primarily on Bank of America (BAC). Now remember that options trading involves a significant amount of risk. You should always know the risks involved in each trade before entering it, including profit/loss scenarios and if you are required to post margin for any trade. Don't forget to take into account commissions, which can take away part of your profits. The following chart shows Bank of America over the past year.

Click to enlarge

(Source: Yahoo! Finance)

As you can see from the chart, Bank of America has been in a range of $5 to $11 (give or take a few cents here and there). In the past 6 months, the stock has been trading between $6 and $8 mostly.

Using those two ranges, if you believe like me that we will stay range bound, you can use options to generate some nice income. How do you do this? Well, you can sell calls at the top end of the range, and sell puts at the bottom of the range. As long as the stock stays in between the range you've set, you pocket some nice cash. If the stock breaks out of the range, you'll be on the hook to buy or sell shares at a given price, which can open you up for some serious losses. More on that later.

So first, let's discuss the $5 and $11 range. The following table shows how much you would receive for selling the $11 call and $5 put. The total is how much you would receive per contract. You must also remember to subtract commissions, which I don't do as they can vary widely from broker to broker. The percent column is that percent you would make, if the trade was successful, based on Tuesday's close of $8.06. So if you made $0.14 in two months, for example, you'd make 1.74%. Over a year, that can add up. Here's the $5/$11 split.

$5 Put, $11 Call Call Put Total Percent
August 2012 $0.01 $0.01 $0.02 0.25%
September 2012 $0.04 $0.04 $0.08 0.99%
October 2012 $0.06 $0.08 $0.14 1.74%
November 2012 $0.10 $0.11 $0.21 2.61%
December 2012 $0.15 $0.16 $0.31 3.85%
January 2013 $0.21 $0.21 $0.42 5.21%
February 2013 $0.26 $0.23 $0.49 6.08%
Click to enlarge

So let's say for instance, you sell the January 2013 $5 put and $11 call. You would pocket $0.42, or $42, per contract of each sold. So how do you make money? Well, as long as the stock stays above $4.58 and below $11.42, you make money. The perfect scenario is if the stock stays between $5 and $11, because then you get to keep all $0.42. However, if it goes above $11 or below $5 by expiration, your profits decrease, until the above mentioned break evens. If it goes outside that range, you start to lose money. For example, let's say the stock goes to $13 by expiration. You sold 3 calls and 3 puts at the strikes I gave. The holder of the $11 calls exercises the option, meaning you have to sell them 300 shares at $11. But shares are at $13, which is what you have to buy them for. So you lose $2 a share. However, since you were paid $0.42 for selling the options, you only lose $1.58 per share, or $474 (for 300 shares, not counting commissions). Your losses are infinite as Bank of America rises, but they are capped if it falls because the stock cannot go below $0. The following chart shows your profit/loss areas. As you can see, there's a wide range where you make money. The stock would really have to move for you to lose money. The stock would have to rise more than 41% or fall more than 43% by January expiration for you to lose.

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Now, that $5/$11 range is based on where the stock has been over the last year. That is a slightly more conservative trade. For someone wanting to be more aggressive, you can use the $6/$10 range the stock has seen over the last 6 months. This gets you more money upfront, but narrows your profit range and extends your loss range. That's why you receive more money upfront, because there is more risk involved. Here's the table (same as above) for the $6/$10 split.

$6 Put, $10 Call Call Put Total Percent
August 2012 $0.03 $0.03 $0.06 0.74%
September 2012 $0.09 $0.10 $0.19 2.36%
October 2012 $0.15 $0.16 $0.31 3.85%
November 2012 $0.21 $0.21 $0.42 5.21%
December 2012 $0.29 $0.29 $0.58 7.20%
January 2013 $0.36 $0.35 $0.71 8.81%
February 2013 $0.43 $0.39 $0.82 10.17%
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For selling the tighter range, you would pocket $0.71, or $71 per contract of each sold for the January expiration. Now obviously, the range in which you can profit from is a lot tighter. You can only make money between $5.29 and $10.71, with maximum profit between $6 and $10. Also, because your profit range is tighter, the potential for losses is greater should the stock break out of the range. But again, that's why you are paid more upfront, for the added risk.

Now, you can do this with any name really. It is just a matter of the range you are going to pick. The table below shows some of the other major financials, including Goldman Sachs (GS) and Citigroup (C). The ranges below are the rough ranges, meaning that they've traded outside those values slightly, but not for any extended period of time.

Symbol 6-month 12-month
JPM $31 to $46 $28 to $46
GS $90 to $130 $85 to $140
MS $12 to $21 $12 to $24
C $25 to $38 $21 to $43
Click to enlarge

Now of those names above, JP Morgan might be one to avoid for now, until the trading loss issue gets a little more resolved. We are expecting to hear more from the company at their earnings report coming up shortly.

As for the other names, Goldman Sachs and Citigroup are a bit below the midpoint of their ranges, so they probably don't make the best candidates for a trade like this right now. I chose Bank of America because it is within pennies of the $6/$10 midpoint right now, which is the 6-month range. Morgan Stanley does seem like a good candidate here. An $11 put/$19 call combo for the January 2013 expiration would currently net you around $1.30 right now, which at $15 seems like a decent payout.

So if you agree with me that financials will be range bound for the next couple of months, you might be interested in an options trade like this. The best part is that you don't need to know which way the stocks are going to move to make money, you just need to figure out how far you think they could move. Now remember, some of these strategies are very complicated and aggressive, so I wouldn't enter one of these if you are just starting out with options. But if you are an options veteran who is willing to take a little risk, you might find yourself collecting some nice premiums here.

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