Options Update: Bank of America Targeted by Heavy Call Activity

Moody’s Investors Service lowered the senior debt ratings of Bank of America
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to Aa3 from Aa2 this morning. The ratings service also cut the long-term bank deposits rating on Bank of America NA to Aa1 from Aaa. The rating outlook is negative. Moody’s said the “downgrade and negative outlook on Bank of America reflect Moody’s view of the greater challenges Bank of America and Merrill Lynch are likely to face over the next few years under a more difficult economic environment.”

Following the news, BAC has seen a swell in call volume, placing the equity on today’s Intraday Volume Explosion List. The activity falls in line with the overall bullish tone among near-term options speculators, as the stock’s Schaeffer’s put/call open interest ratio (SOIR) of 0.62 ranks below 96% of all those taken during the past year. This ratio indicates that investors have been more optimistic toward BAC only 4% of the time in the prior 52 weeks.

That said, 2 block trades in the January 2010 series of options caught my eye this afternoon. A block of 10,000 contracts at the January 2010 15 call, and 2 blocks of 5,000 contracts at the January 2010 25 call, which changed hands at the same time on the same exchange. Volume at both strikes today remains well below open interest, but the apparent relationship between the 2 trades hints that we may be looking at a more complicated trading strategy.

Bank of American option volume details

The Anatomy of a Bank of America Call Position

Digging into this call activity, I noticed that the block of 10,000 January 2010 15 calls traded at the bid price of $3.35 at 9:55 a.m. Eastern. The 2 blocks of 5,000 contracts crossed the tape at about the same time for an average ask price of $0.925. The credit received for the sale of the 15 strike calls totals $3,350,000 — ($3.55 * 100)*10,000 = $3,350,000. The debit incurred by the purchase of the 25 strike calls amounts to $925,000 — ($0.925 * 100)*10,000 = $925,000. We arrive at the total credit of $2,425,000 for this spread strategy by subtracting the debit of $925,000 from the credit of $3,350,000 — $3,350,000 – $925,000 = $2,425,000.

It is unusual to see a credit spread with such a long time span, as these options don’t expire until January 2010, but the premise remains the same. By entering this trade without owning the stock, the trader needs BAC to remain below the 15 level for the duration of 2009. The trade hits breakeven near $19 per share due to premium received on the sold January 2010 25 call, and reaches its maximum loss when BAC hits $25 per share.

That said, if the trader owns enough BAC shares to cover the position, we arrive at another strategy entirely. First, the sold January 2010 15 call becomes a covered call position designed to collect some premium to offset a sideways trend or slow decline in the shares. Should BAC rally above the 15 level, the trader is able to sell his shares at $15 each and keep the premium received from the sold call.

Second, the purchased January 2010 25 call becomes a form of hedge to the covered call position. By purchasing this 25 call, in addition to owning the shares and selling the January 2010 15 call, the trader has ensured that he doesn’t miss out on any potentially sharp rally in BAC shares. If the equity rallies above the 15 level, the shares would still be called away, but an extended rally above the 25 level would keep the investor from missing out on any additional upside.

So, what are BAC’s prospects going forward? Let’s take a closer look at the stock’s technical and sentiment backdrops to see if we can gain some insight.

Getting Technical

From a technical perspective, the stock has dropped more than 64% during the past 52 weeks, edging out the S&P 500 Index’s (SPX) loss of more than 35% for the same time frame. The stock continues to struggle with overhead resistance at its 10-week and 20-week moving averages. Despite a handful of weeks in September and October 2008, these intermediate-term trendlines have forced BAC steadily lower since October 2007. Furthermore, short-term resistance appears to be building at the 15 level. The shares have not closed week above this region since late November 2008. Clearly, this backdrop favors the sold January 2010 15 call, as BAC has failed to prove it can maintain any form of technical strength for longer than a few weeks at a time.

Weekly chart of Bank of America since October 2007 with 10-week and 20-week moving averages

The Sentiment Drivers

Sentiment toward BAC also points toward an extended downtrend for the shares. Wall Street analysts have sided with bullish options traders, as 8 of the 17 brokerage firms following the equity rate it a “buy” or better, according to Zacks. Furthermore, there is little fuel for a short-covering rally, as only about 2% of the stock’s float is sold short. Once again, it would appear that a sold 15 strike call could be a pretty stable investment.

Sentiment indicators for Bank of America

The Verdict?

I’m not convinced that today’s unusual options-trading example is the best course of action for everyday traders, especially considering that the size of the block trades points toward institutional activity. If you have the means and wish to protect your BAC portfolio while maintaining exposure to the shares in order to capitalize on a surprise 2009 rally, the strategy could work. For the rest of us, a put option or a sold call position (in the February or April series) might be a better course of action. BAC looks poised to extend its decline, and the wealth of investor sentiment could serve to exacerbate the situation if these bulls have a change of heart.

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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.