This article is part of our Rising Star Portfolios series. Sean is co-manager of the Dada Portfolio.
We think Bank of America (NYSE: BAC ) and Lender Processing Services are going down. Yesterday, my fellow Dada Portfolio co-manager, Ilan Moscovitz, explained why he felt that bearish positions on BAC and LPS would be a great way to play the unfolding mortgage fraud crisis that has the potential to be a thorn in the side of mortgage servicers like Bank of America, JPMorgan (NYSE: JPM ) , Citigroup (NYSE: C ) , and Wells Fargo (NYSE: WFC ) .
Not being much of an options man myself, I learned a lot by thinking through this trade and trying to figure out what the best course of action would be. I'm going to try to explain our thinking today -- why we planned on splitting $800 between LPS puts and a Bank of America short -- but also why we've had to change our original play. (Read today's LPS article by clicking here.)
Bank of America puts
The first thing we considered was Bank of America puts. A quick primer: Buying a put option gives you the right to sell a share of stock at a given price (the strike price). For that right, the buyer of the put has to pay a premium, or in other words, the cost of the option itself. As an example, with Bank of America trading around $12.70 on Monday, you could buy a $20.00 put that expired in January 2012. Owning the put would mean that you could buy BAC shares on the open market at $12.70, and then, once January 2012 came around, you could sell those shares for $20.00 -- a guaranteed gain of $7.30 ($20.00-$12.70). Seems too good to be true, right? The catch is the premium -- it cost $7.70 just to buy those put options! So at $12.70 a share, buying the put options would actually net us a $0.40 loss per share ($7.30-$7.70).
If, however, BAC's stock price fell even further from $12.70 -- let's say 10% -- so that by January 2012, BAC traded at $11.43, we would be able to buy Bank of America stock on the open market for $11.43 and then sell those shares for $20.00 -- a value of $8.57 ($20.00-$11.43). Now, the $7.70 premium that we paid for that option all of a sudden yielded an $0.87 gain for us ($8.57-$7.70)! An $0.87 gain on $7.70 invested would mean a return of 11% ($0.87 ÷ $7.70).
Here is a table that illustrates various put strategies and their outcomes:
That's why buying puts is considered a bearish strategy (because you're hoping for the share price to go down). And that's what we have in this chart. This chart shows the put options for Bank of America that expire in January 2012. We list the options by strike price in the first column on the left. To the right of that column we have the premiums for those particular options -- again, how much the options cost, per share. And all that colored stuff, those are the returns for our options if BAC's share price moves 15%, 10%, 5%, and so on. So to read the chart, you can look at the fourth row from the bottom: $20.00 puts with the $7.70 premium would yield us an 11% return if BAC's stock falls 10% -- exactly like we calculated earlier.
The returns that are in green font are there to show when our options are really making more sense than a simple short. If we were to short BAC's stock, our returns would be the exact opposite of how the stock performs. If BAC fell 10%, we'd gain 10%. If BAC gained 20%, we'd lose 20%. Buying puts would juice those returns a little. With options, we can put in less capital to earn a higher return. Look at the $12.50 put options with a premium of $1.92. If Bank of America shares fell 30%, those options would return 88%, almost three times more than what a standard short would have yielded.
What we really want to see is an option that gives us leverage on the gains we would see if the stock fell, but also downside protection in case our thesis is wrong. Out of all the options in our chart, the only ones that seem interesting to us are the puts with the $22.50 strike price and the $9.90 premium. Those would start giving us a little leverage as soon as BAC's share price falls just 5%, and we wouldn't be hurting too much worse than if we were straight up shorting if Bank of America shares gain on us.
But one more problem: Each options contract represents 100 shares. For us to buy the $22.50 puts, we'd have to pay $990 (100 x $9.90 premium per share). The Motley Fool is giving our Dada Portfolio $17,000, so $990 in this one position would mean a nearly 6% position, and one without an acceptable return to offset the considerable risk we'd be putting ourselves at. We pass.
For Dada, on this play at least, we'll just stick with good ol' fashioned shorting -- $800 ($200 for Bank of America, $600 for LPS), or just south of 5% of our total capital, on our thesis that the mortgage fraud crisis still has plenty more downside.
Colossal bragging rights or epic fail? Let us know what you think in the comments below. Or visit our discussion board here and follow the whole saga on Twitter @TMFDada.
The Dada Portfolio is a part of the Rising Star series of real money portfolios. It is co-managed by Sean Sun and Ilan Moscovitz. A full list of our articles can be found on the Dada Portfolio Foolsaurus page.