Recently, Bank of America (NYSE: BAC) has been hit by another wave of troubles from the ongoing legal litigation haunting the bank since the financial crisis of 2008-2009, when it bought Countrywide Financial Corp. with its mortgage securities issue.
I am long Bank of America in the long run for many reasons, predominantly its improving profit margins and a very conservative leverage and the quality of its balance sheet, coupled with more normalized conditions in both consumer and commercial banking.
However, considering the short term, as a result of the $8.5B settlement case being questioned by AIG, Bank of America's stock has been under pressure and its volatility has risen considerably.
This short-term uncertainty will result in a one-off extra liability in the worst case, and in no change in the best case. Either way, there will be no long-term liability or long-term impact on BAC's business operations as such. They will continue to perform well and generate future profits. As a result, I see this short-term stumble and risk as a great long-term buying opportunity.
In addition to BAC's increased short-term risk, the overall markets are taking a break and started see-sawing, which raised the overall market volatility as well. This sudden volatility surge in both the overall market and in Bank of America in particular, present a very interesting short-term opportunity for long-term BAC stock holders, as well as those investors who would like to initiate a new position or add to existing positions in Bank of America.
How to profit from Bank of America's short-term uncertainty?
1. Simply buy the stock
One way to take advantage is to just simply buy BAC stock at this time when it is under downward pressure, and be ready for short-term losses and weather the short-term storm of risk and volatility.
2. Short-term covered calls on BAC stock positions
I seldom recommend using covered calls as a continuous, long-term strategy. However, it can be very profitable as a one-off trade to take advantage of very specific market conditions in a particular stock.
Now is exactly the time to employ the covered call strategy for BAC stock holders. For long-term investors who want to remain long on the stock during this turbulent period, this is the perfect time to write short-term covered calls on their BAC holdings - until it becomes clear whether BAC could face higher liabilities due to AIG's objections, and if so, how big these additional liabilities might be.
I propose using out-of-money calls approximately 6% up from the current stock price to keep room for potential stock rise following a positive resolve of the short-term uncertainty factor of the AIG objections.
The 6% out-of money July 2013 calls generate approximately $13 in time premium per 100 shares, which represents 1% additional return as a result of selling the options time premium in just one month, or a theoretical 12% annualized extra return on capital invested in the stock.
Of course, investors face the risk of being called away if the BAC price rises above their options strike price by the expiration. However, the return is well worth the risk, especially since the situation around BAC is really unclear at the moment and the stock might even fall by the expiration from its current levels.
Investors should see this risk of being called away as a price they pay for the possibility to generate additional income, while also decreasing their downside risk by the amount of the options premium. This double bonus is well worth the risk of being called away. In the case of being called away, an investor would realize any unrealized profits up to now, plus another 6% up from the current price, which is an excellent return by itself.
3. Selling short-term out-of-money puts
Alternatively, if investors would be willing to buy more Bank of America stock should its price fall by a certain amount as a result of an adverse AIG case outcome, or any other reasons, thanks to current heightened volatility, it is very profitable to also sell out-of-money puts on this stock. The July 2013 put with a strike price approximately 7% lower than the current BAC stock price generates a $10 time premium for each 100 shares of BAC, which represents an approximately 0.8% return based on BAC's current price; this is a theoretical annualized return of approximately 9%.
Please note that I urge investors not to use leverage in terms of the overall size of their portfolio and the maximum theoretical loss from all of their positions; therefore, I always calculate options returns based on a theoretical full stock position, even though investors could use margin and decrease capital needed for the position by using put spreads instead of plain naked puts.
If the puts are called, you acquire BAC shares at a deep discount from its current price and keep the options time premium. If not called, you don't get to own the stock, but retain very interesting short-term profits from the options time premium.
In conclusion, I am bullish on the BAC stock in the long term. Therefore, I believe that the current short-term risk and increased volatility in the Bank of America's stock offers long-term investors a multitude of ways to make short-term profits and/or establish long-term positions at a good price when stock is under temporary downward pressure, which will resolve itself within a few weeks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.