How to Buy Bank of America at a Discount and Generate Income Using Options
Many investors think buying and selling options is more dangerous than playing with fire.
In this article, I will illustrate an example of building a stock position in a very cheap and safe way using options.
There are 3 steps to this process:
- Identify a stock you would like to own, preferably a strong company with fundamentals favoring its upside, or having limited downside.
- Buying your stock cheaper by selling "cash-secured" puts.
- Once you get the shares assigned to you, how to generate income for the shares by selling "covered" calls.
Step One: Identifying a stock you would like to own
I will use Bank of America (BAC) for this example since their options have a lot of liquidity, trading millions of contracts daily. Their Average Option Volume is 2,654,872. I also chose Bank of America because we all know the Fed will not allow any big bank to fail, and will bail it out if needed, so its downside is limited.
I do not advise trading options on stocks that have thinly-traded options (less than 1,000 contracts traded daily). Always check the average option trading volume before trading options. Thinly-traded securities will result in very wide ask-bid spreads.
Option Basics, Calls and Puts
Each options contract represent 100 shares, for both calls and puts, always.
I will start with the some basics and the 2 types of options; feel free to skip this part if you already know them:
Call contract: The right (but not the obligation) to buy a stock (or bond, commodity or other financial instrument) at a specific price within a specific time period. There are 2 players in this contract, the seller and the buyer of the call.
If you buy the call, you have two options:
- Exercise the right to "call in" (buy) Bank of America shares, 100 shares per contract purchased.
- Sell the call option to another person once the contract you bought is more expensive than when you bought them, this happens if Bank of America rises in price and the time decay has not eaten away your profit.
Time decay (also known as theta) is very powerful; option sellers know this, and since around 90% of options go unexercised, time is in your favor, and a call seller could walk away with a profit even if Bank of America rises in price if the stock does not rise fast enough.
If you sell calls, you profit if your underlying stays below the strike price until expiration.
Stock Options expire the 3rd Friday of every month. So if, for example, you sell $9 calls for July 2012, you would profit if stays below $9 until expiration Friday, which would be July 20th.
Put contract: The right (but not the obligation) to sell a stock (or bond, commodity or other financial instrument) at a specific price within a specific time period. If you buy the put, you have the right to "put" your stock to somebody at a specific price. If you sell Bank of America $9 puts for July, you are selling someone the option to sell you their stock at $9. We will go step-by-step next, do not worry if you did not understand something, and also feel free to ask in the comment section.
Step two: Buying your stock cheaper by selling "cash-secured" puts
So you already chose to build a stock position on Bank of America. To get the shares at a discount, instead of buying the stock outright right now at $7.70, you are going to sell put contracts to choose your price.
We will assume you have $10,000 to build your Bank of America core position; you can adjust this quantity to your investment plan. If you bought the shares today at $7.70, you could buy 1,298 shares (minus commissions).
This price is too expensive for me, can I get a discount? Of course you can.
You have to keep the $10,000 in your account in cash at all times until expiration.
Then you check the Option Chains for BAC for October, which should look something like this:
You would then sell 15 BAC $7 puts for October 2012 at $0.43 each (the bid price); and since each contract equals 100 shares, this means you would receive $43 per put contract sold. So you would rake in $645 minus commissions. The downside is you cannot trade or invest that $10,000 on anything else until expiration Friday comes the 3rd Friday of October. That is why they are called "cash-secured" puts, because you always have the cash to buy 1,500 shares of Bank of America at $7.
There are 2 scenarios:
- The Bank of America shares drop in price below $7 from here to October 19th and the put option buyer exercises his/her option, your broker automatically buys the shares (this is also called "getting assigned"). Since you sold 15 contracts, this would normally mean a $10,500 purchase (15 contracts*100 shares per contract=1,500 shares you have to buy, at $7). But since you sold 15 put contracts and received $645 up-front, the cost of the shares would go down to $6.57 each. ($10,500-$645= $9,855), then $9,855/1,500 shares=$6.57 cost per share.
This is a 14.6% discount on the price today. Notice you also bought 1,500 shares instead of the 1,298 you would be able to buy today at $7.70.
2. Bank of America shares stay above $7, the put option buyer would not exercise his/her option because they can sell their shares on the market for a higher price. You keep the $645 premium and do not get assigned any shares. This would mean a 6.45% ROI from today until October 19th, or 25.8% annualized.
Ideally, scenario 2 would play out at least two or three times before you get assigned, and if you keep selling as much puts as you can, you will be able to buy a lot more shares (compared to the original $10,000 you had to purchase the Bank of America shares).
Let´s say you repeated this process three times in one year before getting assigned the 4th time, and the prices you sold your puts at were exactly the same (they never are, but stay with me) for each time you sold puts 3 months out (3 months until expiration), you would have:
$10,000+$645= $10,645, you would then be able to sell another 15 put contracts at the $7 strike price, collecting another $645.
$10,645+$645=$11,290, you would then be able to sell 16 put contracts at the $7 strike price, collecting $688 this time.
$11,290+$688=$11,978, you would then be able to sell 17 put contracts at the $7 strike price, collecting $731 this time.
$11,978+$731=12,709, you would then be able to sell 18 put contracts at the $7 strike price, collecting $774 this time.
This would leave your account with $13,483 minus commissions, if you get assigned the 4th time you sell these 18 put contracts, you have to buy 1,800 shares of Bank of America (18 contracts*100 shares per contract).
You now have $13,483 in your account, so this would mean your cost basis would be lowered to: $13,483/1800= $7.49 per share. And you got 1,800 shares instead of 1,298. This equals more than 500 additional shares.
Remember that only the first $645 collected is with the real data, the other 3 times is what could happen if the price and volatility of Bank of America stayed the same for a year (which most probably will not happen, but you get the idea).
The plan is to keep selling puts 3 months-out until you get assigned, for this case, a good strategy is to keep selling puts $1 out-of-the-money. If BAC shares drop to $7 on October, for example, you would sell January 2013 $6 puts, not the $7 ones, since you have a higher chance of getting assigned. Do not sell put options too far out-of-the-money, because the premium collected on the sold puts will get a lot smaller.
Step Three: How to generate income for the shares by selling "covered" calls
Assume the market turned against you and you got assigned BAC shares the first time you sold them, and you now have 1,500 shares at a cost of $6.57 each.
The plan now is to sell out-of-the-money calls until your shares get "called" away.
October has come, and you have the choice to sell $8 BAC calls for Jan 2013 at $0.56 ($56 per call contract sold). You can sell up to 15 of these contracts since you have 1,500 shares.
Note: The $0.56 is the price as of today of October 2012 BAC $8 calls, if the price of BAC stays the same, we should have a similar price; if it goes higher, go 1 strike higher than the price ($9 strike if it is around $8.15, for example). If it goes lower, to around $6, you should sell BAC $7 calls for January 2013.
The plan is to sell 1 strike above the current price so you can collect the most premium, if you go 2 strikes higher, your collected premium, along with your probability of getting your shares "called away" (automatically sold by your broker) diminish.
There are 2 scenarios:
- BAC shares go up in price and now the calls you sold are in-the-money, which, for this example, means that they are above $8, and the call buyer exercises his/her right to buy those 100 shares per contract at $8. Your broker automatically sells your 1,500 shares, but you keep the $840 premium for the 15 call contracts you sold.
Your income would be $840 for those 3 months. This would give you an 8.5% return in 3 months, 34% annualized, leaving you with $145 left from your original purchase of 1,500 shares of BAC when you got assigned: $10,645 from your 15 put contracts sold plus the original $10,000, minus $10,500 for the 1,500 shares purchased at $7 each) = $145 plus the $840 income from the calls sold = $985 plus the original balance in your account =$10,985.
This is a 9.85% return in 6 months in this case, 19.7% annualized, minus commissions.
Commissions should not be more than $100 for all these transactions, if they are, look for another broker.
Keep in mind that the chance of getting assigned shares the very first time you sell your "cash-secured" puts and getting your shares "called away" the first time you sell your covered calls is low, I would say very unlucky, and you still walk away with a profit.
2. BAC shares stay flat or do not go above $8 by expiration, in this case, you would keep both your shares and the $840 premium, and you would look to repeat the call-selling process until your shares get called away.
The beauty of this strategy is that it is simple, one of the safest involving options, and after your shares get both assigned to you and then called away, you can repeat the process indefinitely.
Give it a try, at least in a Virtual Account to check how you would do, and of course it is applicable for any stock.
If you do not like this stock for performing this strategy because you would not like to own it, you can pick one of your favorite stocks, be it Microsoft (MSFT), Apple (AAPL), Exxon (XOM), Caterpillar (CAT), Johnson & Johnson (JNJ) or whichever you like. Also consider that dividend-paying stocks will pay you as long as you have the shares in your account.
If you have any questions regarding this strategy, post them in the comment section below.
Disclosure: I am long TEF. Also short SPY call spreads.