Saturday, November 6, 2010

UPDATED: Betting on a Bank of America Bounce (BAC; XLF)

The stock closed at $12.36 up 1.9% on Friday.
See also: "A Secret Route to Banking's Potential Riches" (BAC; HIG; JPM; WFC)

From Barron's:

Options traders see a rebound, albeit limited, in the beleaguered bank's shares.
A RISING TIDE LIFTS ALL SHIPS – even Bank of America (ticker: BAC).
As many investors wait (and hope) for clarity about the bank's liabilities from potentially faulty home foreclosures, aggressive traders are buying bullish call options in anticipation the stock rebounds from its oversold slump.

When the stock was at $11.45 (it has since moved up to $11.80), Morgan Stanley, for example, advised clients to buy B of A's January $12.50 calls, and sell January $14 calls to profit from a "quick, but limited rebound from trough price/book levels."

If the trade modeled by Christopher Metli and Sivan Mahadevan works, investors would realize a 4.2-to-1 return on their wager. If Bank of America stumbles, investors would lose the 29 cents spent to establish the position.

To be sure, the Bank of America snapback trades are not propelled by any substantive belief about a change in the bank's earnings fundamentals, according to traders active in its stock and options. These trades are driven by the simple facts of crowd psychology. (None of the traders interviewed can be identified because they are prohibited by their banks from speaking to reporters.)

Stocks often snap higher simply because investors become too negative. The Federal Reserve's latest attempt to stimulate the economy also makes it very attractive to own stocks, especially shares that have fallen sharply, and financials especially. Bank of America's shares are down 36% in the past six months, and even now are not far from their 52-week low of $11.03.

"We feel the stock has found a bottom around $11.50," says one senior trader at a major bank who is speculating the stock rebounds higher during the next few months. Beyond that, it is hard to say what happens to Bank of America.

To be sure, the Charlotte, N.C. bank suffers from the curse of Citigroup (C). Sprawling, and massive, Bank of America and Citigroup are involved in so many different businesses that there is always one unit that can, as a senior financial trader at a major firm says, "bite you in the ass even if everything else is working out."
Proof: Bank of America seemed recently poised to emerge from the confines of a murky $2.8 billion acquisition of Countrywide Financial, a major mortgage lender. Since then, many investors have struggled with concerns that the deal exposed B of A to hard to quantify risks. The latest mortgage-putback concerns stem from loans in large part made by Countrywide. B of A stock is now hobbled by allegations from Pimco, BlackRock, and the Federal Reserve Bank of New York that essentially accused B of A of peddling $47 billion of mortgage-backed securities filled with bad loans. That could force B of A to repurchase the bad loans the MBS holders put back to the bank.

Nonetheless, the current round of bullish speculation is a marked reversal from recent weeks when concerns about the bank's exposure to potentially problematic home foreclosures prompted investors to dust off bearish playbooks last used during the worst of the financial crisis.

The hallmark of those dour machinations is buying put options that would increase in value if the stock price plummeted. (See Striking Price Daily, "Will Bank of America Shares Fall Hard?" Oct. 20, 2010.)
To be sure, puts that would increase in value if the stock fell as low as $2.50 by January are still held by some traders, at prices that still reflect fear of a sharp decline. But Bank of America is benefiting as many investors are getting "bulled up" following the Republican victories in the midterm election, which may portend less stringent financial regulation, and the Federal Reserve's plan to inject $600 billion of liquidity through Treasury securities purchases.

"We have seen an explosion of XLF (Select Sector Financial SPDR) call buying today, following a trend that began Friday," a senior sales trader at a top European bank e-mailed clients late Thursday morning. The XLF call buying will benefit Bank of America's stock because the shares represent almost 7% of the exchange-traded fund's value.

For now, the trend is your friend – until it bends.
Monday Follow-up: "Bank of America a Good Two-Month Bet, Morgan Stanley Says"
Also at Striking Price Daily:
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Bet Against International Game Technology

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  • A Starbucks Bull Trade