New Trade: BAC That Spread Up

by Dan February 3, 2012 2:13 pm • Commentary

Here is a little Preview of what I will be discussing on Options Action tonight at 5pm on CNBC:      

BAC ($7.80)  Stock is up 40% ytd and 60% from the 52 week lows made in DEC. While the stock may have been severely oversold heading into the new year, it might have gotten a little ahead of itself in the near term and a re-tracement of a portion of the recent move could be in the cards in the months to come.

Here is a relatively low risk way to play for a pull back in the shares btwn now and May expiration, with the worst possible scenario that you are Put the stock at $6.00 (really $5.03 when you include the gains of the spread as if it was 1 up), that is down 35%!


TRADE: BAC ($7.80) Bought May 7 / 6 1×2 Put Spread for .03

-Bought 1 May 7 Put for .41

-Sold 2 May 6 Puts for a total of .38

Break-Even May Expiration:

Profits btwn 6.97 and 6.00 make up to .97, profits trail off btwn 6.00 and 5.03

Losses of .03 above 7.00 and up to .03 btwn 6.97 and 7.00……

MAX RISK, if stock is 6.00 or lower you are Put the stock, but you have made .97 so effectively you are protected to 5.03, SO YOU WOULD ESSENTIALLY BE LONG THE STOCK AT 5.03 (down 35% from current levels)


TRADE RATIONALE:  The company clearly seems to be “out of the woods” so to speak, but don’t think for a second that if we get a re-emergence of debt fears in Europe, that investors won’t hit the pause button in U.S. banks that have enjoyed fabulous gains over the last 6 weeks.

I want to reiterate that I have no strong negative fundamental view on BAC, This is merely a low premium way to get exposure to a move lower, that offers a very wide point in which you would lose real money on this trade.  I LIKE THE RISK REWARD.

Think of it as a put spread with an equal number of short puts added. If you did this trade 5×10, you would be long 5 of the 7′s, and short 10 of the 6′s. If the stock went down a lot it would be the equivalent of being long 500 shares at 5.03. The 500 shares being the extra 5 puts you are short in the spread. The pricing of the options and the fact that it is a 1×2 ratio means you have a long distance in the stock falling before that starts to be a problem,and a pretty big range on a more moderate drop where you can make a profit.

So it’s isolating a downward range in which one can profit, w/o risking much in premium, the flip-side, is in order to get that low premium risk, you need to be willing to step in and be long at a much lower level.
More importantly, because this trade is such a low premium bet... that doesn’t mean one can size up and do this thing a million times. The contract amount on a ratio spread must take into account how long you would be willing to be at 5.03 in a distressed stock like Bank of America

So keep that in mind on trades like this. If one didn’t want to own 10k shares of BAC at 5.03, one doesn’t do this trade 100 times. Because it’s possible that’s what would happen in the worst case scenario.

If you wouldn’t be that stoked to be owning this stock at 5.03 because of what that would entail (bank stock craziness!) the sizing of your trade has to take that into account.