A Bear Case For Bank Of America
Last December, we noted that Bank of America (NYSE:BAC) was one of the Portfolio Armor website's top 10 names, and that dark pool investors were also bullish on it, as indicated by Squeeze Metrics data (Bank of America: Signals Align). Since then, BAC is up about 8%, but the signals are no longer aligned.
Our website is still bullish on BofA, albeit slightly less so: It's now a top 20 name, rather than a top 10 name, with a potential return estimated at about 23% over the next 6 months (actual returns have averaged about 0.3x our site's potential return estimates, historically). But recent dark pool data hasn't been bullish as the chart below via Squeeze Metrics shows.
Recall that dark pools are private exchanges where hedge funds and other institutions trade to avoid front-runners in public markets, and that the DPI, or Dark Pool Indicator, represents the percentage of dark pool trades that are buys (often there isn't an equal number of buy and sell trades in dark pools, because some of the sales are routed to public markets by liquidity providers such as high frequency trading firms). We've highlighted Monday in the histogram above, and you can see in the data box in the top right of the chart that BAC's DPI was in bearish territory then, at 37%. The DPI was bearish for BAC (below 50%) in 8 of the last 10 trading days.
Now, Renaissance Research has presented its bear case for Bank of America, seeing a 28% decline in a worst-case scenario of rising credit costs and lower net interest margins. Renaissance writes that,
[W]hile there is material upside potential for Bank of America, investors should be aware of the downside risks. With that being said, BAC's shareholders might take comfort in knowing that the stock still has a reasonable risk/reward ratio.
We offer a couple of hedges below for investors who want to clip off most of the risk in that ratio.
Adding Downside Protection To Bank of America
If you'd like a refresher on hedging terms first, please see the section titled "Refresher on Hedging Terms" here). We used the Portfolio Armor iOS app to find optimal puts and an optimal collar for BAC, but you can find optimal hedges without it using the method explained here.
Both of these hedges are designed to limit your downside risk to a drawdown of no more than 13%. You can try different parameters if your risk tolerance is higher or lower than that, but the hedging cost may vary accordingly.
Uncapped Upside, Higher Cost
These were the optimal puts, as of Monday's close, to hedge 1,000 shares of BAC against a greater-than-13% drop by mid-August.
As you can see above, the cost was $640, or 2.62% of position value. Bear in mind that this cost was calculated conservatively, using the ask price of the puts. Since you can often buy them for less (at some price within the bid-ask spread), you would likely have been able to open this hedge for less than $640. For investors sensitive to hedging cost, the next hedge may be of more interest.
Lower Potential Upside, Negative Cost
As of Monday's close, this was the optimal collar to hedge 1,000 shares of BAC against a >13% drop while not capping an investor's upside at less than 6% by mid-August.
The algorithm was able to use a less expensive put strike here due to the net cost of the hedge. The cost of the put leg above was $430, or 1.76% of position value. And as you can see below, the income generated from the short call leg was more than double that, $890, or 3.6% of position value.
So the net cost here was negative: An investor opening this hedge would have collected $450, or 1.84% of position value. As in the first collar, the cost here was calculated conservatively, so, in reality, an investor opening this on Friday would likely have collected more than that.
So the potential upside here would have been closer to 8%, than the 6% the collar was capped at [6% - (-1.84%)] = 6% + 1.84% = 7.84%.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.