Bank of America (BAC) : A Speculative Trade

Before I start the post, let me warn that trading into financial is full of risks and you may lose your capital. You should make sure that you have a proper risk management plan in place to handle this and should only invest what you might be willing to lose 100%. And this particular trade you should not try if you think BAC is headed for bankruptcy/ nationalization, wiping out shareholder’s equity. (As a general suggestion, one should never invest more than 2-3% into any speculative trade. A good money management is extremely important as these have high risk for losing capital.)

There are some bearish news on BAC. According to Oppenheimer & Co,  Bank of America Corp., the largest U.S. bank, needs to raise $36.6 billion in equity to bring capital ratios in line with its peers. The news has driven IV higher. In any case IVs were already high on BAC and other financial stocks.

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So how to play a possible speculative trade on this-

I am opening a LEAP calendar spread on this. Which is BUY TO OPEN Jan 11 7.5 calls for $3.5 and SELL TO OPEN May 7.5 ATM calls for 1.13, netting only $2.35/spread. I am treating it as covered call which means I shall continue to write ATM/OTM calls against my leap. I need to roll it only almost 2-3 more times to get back my cost. If however by May expiration, BAC continues to hover around 7.5, the returns will be > +40%. However the chances of staying flat are very dim. The trade has $5.8 and 12.4 as break even points by May expiration as per current IV profile. After 2-3months, LEAPS are free for remainder of the life assuming BAC doesn’t file for bankruptcy or for nationalization and hence the risk.

So the chance of making money for this trade is only under “No Nationalization” or any other ” Significantly Bad News” thus causing the stock to drop to peanuts; even if it drops to the levels we saw earlier i.e. $2.5 or so, I expect near month ATM to generate $0.30 to $0.50 thus breaking even in a few months. It will be free thereafter.

Net, if the conditions remains either as now or better, this trade may make money (If it does deliver +20% or so quickly, I may just get out completely). If conditions are bad, this may still make money, but if conditions are worst i.e. nationalization/Bankruptcy etc, it will lose money. You may also want to stress test for various IV profiles.

Disclaimer– As of this writing I own this spread. I may change my position anytime without notice.