Financial shares are bucking the downtrend in Monday’s market, with Bank of America (BAC) adding 1.28% to $16.21 per share even as the broader S&P 500 index is lower by 0.26%. Options trading in the lender is also showing a bullish bent with 169,000 contracts in play and topping the list of most active by option volume.
The bigger option plays are in the nearby January expiration with 15, 16 & 17 strikes popular with bulls. Those betting on a recovering economy and a steepening of the yield curve that may boost earnings at financial companies continue to favor the sector as a whole. Bank of America for example has vaulted from $13.75 per share at the end of the first week of November and used the record advance for the S&P 500 index as reason enough to jump to its highest value since May 2010.
Chart – Bank of America has come along way since mid-November
While we have no problem with the current advance in financials even as the broader market struggles, it got us thinking about what the options market is currently forecasting for Bank of America. The Probability Distribution (PD) through March 21 expiration options series suggests that Bank of America’s share price may settle between $16-17.00. Its PD is remarkably symmetrical according to prevailing option premiums.
By using the IB Probability Lab to play around with the projected settlement price by March 21 expiration we asked the tool to generate its top trades assuming that the rush to get long Bank of America hits a brick wall. The top suggestion was pretty interesting. In the following chart the blue lines represent the current market implied probability of landing between two strike prices by March 21 expiration. The red line represents our custom built scenario. For this we simply dragged the line higher to show a stronger chance that by then shares in Bank of America will have slipped to between $14.50-15.00. In fact we assigned a similar likelihood of a setback to that price bucket as the market currently assigns to it standing still over the coming three months.
Chart – IB Probability Lab offers a bearish and bullish solution in the event of a setback
So, when we ask the IB Strategy Scanner to build options trades that suit a potential share price setback in Bank of America, the top trade adjusted by the Sharpe ratio is a 17/18 strangle. In this case the Probability Lab suggests the purchase of the 17-strike put combined with the purchase of two 18-strike calls. This is illustrated below in the upper panel showing p/l for the strategy. The lower panel helps visualize the concept in exposure terms by considering the Delta on the combination. At prices below the 17 strike the position is bearish and therefore accrues profits should the share price slip. At prices above 18 the position is bullish but with two-times the number of bullish contracts as there are bearish contracts at lower prices. Using the right-hand scale, you can see the range for Delta runs from negative-one to positive-two at the extremes of the associated strikes. That’s an interesting premise in today’s environment as financials run north while the market trickles south.
Chart – Bank of America strangle