How We're Shorting Bank of America

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.

Sean does not own any shares of any company mentioned. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (11)

Comments from our Foolish Readers

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  • Report this Comment On December 22, 2010, at 6:38 PM, rd80 wrote:

    I'm curious. For the options strategy, you were looking for "downside protection in case our thesis is wrong," but by shorting you have no protection if you're wrong.

    Are you using a stop-loss, just watching closely or ?? to limit potential losses.

    If the dollar values allowed for a 100 share position, would you have bought an out-of-the money call as insurance in case the market goes against you?

    Very good explanation of what you're doing. Don't like the trade much, but the article is great.

    Fool on!

    Russ

  • Report this Comment On December 22, 2010, at 7:13 PM, stockmajor wrote:

    I believe that you will regret this play. The banks are ready to rally and I think they will do quite well in 2011. Speaking of BAC, have you noticed the big up move in the stock value the past couple of days?

  • Report this Comment On December 22, 2010, at 10:35 PM, summitclark wrote:

    Are these real life trades? Your seriously shorting 15 shares of a BAC? The stock would have to go down a dollar just to break even( assuming $7.5 per trade) So if stock goes down 7% you break even.

    $200 =15 share at 13 a BAC share

    15 round trip to execute trade

    BAC goes to 12 you break even.

    Also do you have a stop in place? Unlimited risk shorting BAC or any stock.

    I understand you guys are trying to make a diversified portfolio with just 17K but why make 20plus investments and pay so much to execute them all. Why not pick 5-10 at the most. Easier to track and still well diversified.

    -andrew

  • Report this Comment On December 23, 2010, at 10:47 AM, TMFSun wrote:

    Hey Russ: thanks for the question!

    If you look at our chart again quickly, you'll see that the options we were looking at give us leveraged downside as well. So the $17.50 strikes, for instance, would be down 11% for us if BAC shares went nowhere, and they'd be down 46% if BAC shares rose just 15%!

    When we say we want downside protection, yes, the maximum we can lose on our puts is 100%, whereas with a short position, theoretically, we could lose infinite%. But the difference is that with these puts, as you can see, it's much, much, much quicker and faster to the road to -100% than a short would be. With a short, we only risk -100% if BAC doubles. If that indeed happened, I'd probably be more worried about flying pigs than the $200 we have committed to this position ;)

    And yes, we are going to be monitoring our short closely. Ilan and I have been talking about a "hard stop" -- a no-excuses, time to say uncle, we've reached our pain threshold point. We're thinking somewhere around -20 to -40% (in other words, BAC rises 20 to 40%).

    Also, we did look at some calls, and they're pretty cheap if I remembered correctly. The calls would've been more interesting if we were buying puts on BAC. But since we're just doing a straight short I didn't feel we needed them that much. Again, arithmetically the risk seems bigger than buying the puts, but probabilistically, I think we're taking the much safer route here.

    Thanks again and feel free to hit up our discussion boards for more questions!

    -Sean

  • Report this Comment On December 23, 2010, at 10:56 AM, TMFSun wrote:

    summitclark: Great observation. We were worried about that too but our broker (Interactive Broker) has really, really, really great fees that scale with the order. For 15 shares I think our commission comes out to be less than a nickel ($0.05 -- seriously) or something outrageously cheap like that.

    In any case that's why we can afford to be more diversified. But you're absolutely right, if we were paying $7 per trade or something like that, this wouldn't make sense at all. Great insight again!

    -Sean

  • Report this Comment On December 23, 2010, at 11:25 AM, summitclark wrote:

    Thanks for the reply.

    5cents per trade? Crazy cheap to trade on there site. There must be other restrictions to be recieve such a price.

    Still disagree with having 20+ positions with an account of 17k but best of luck.

    -andrew

  • Report this Comment On December 23, 2010, at 1:00 PM, rd80 wrote:

    Thanks Sean.

    + ten cents

  • Report this Comment On December 23, 2010, at 1:05 PM, imtired20042004 wrote:

    I think your going to regret your short when next year they increase the dividend.

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