NEW YORK (
Bank of America
is a "top pick" among the big banks at Morgan Stanley, and the firm recently came up with an interesting options play on the stock that looks to juice up the profit potential from its upside expectations for the next few months.
Call options give an investor the right, but not the obligation, to buy stock at a certain price within a specified period. Morgan Stanley analyst Betsy Graseck outlined a trade on Thursday calling for investors to purchase a May 16-18 call spread on Bank of America shares they own. That translates to an investor purchasing a call option with a strike price of $16, while simultaneously selling a call option to buy the stock at $18. Graseck quotes the cost of setting up this spread at 49 cents, reflective of Bank of America shares trading at $14.67 at the time the note was written.
The breakeven point on the spread, according to Graseck, is hit if the stock reaches $16.49
the lower strike price plus the cost of the trade, a level that was roughly 12.5% above where the stock was trading. The most profitable outcome for the trade comes if the stock trades up to $18. After that, the upside is limited, but in exchange for this capped maximum appreciation, the investor's downside on the trade is also limited to the cost of the spread if the stock is below $16.
In other words, downside on the proposed call spread is 49 cents if the stock trades at $16 or below, while there's the chance for a maximum profit of $1.51 if it sails to $18 or higher.
Bank of America shares closed at $14.63 on Thursday. Though options prices have come down considerably, they are still expensive, according to Graseck, indicating that she's not the only one with a bullish view.
Graseck believes Bank of America stock is actually worth $28, a 90% difference, and her 2010 earnings estimates are 70% above consensus analyst views. She rates Bank of America as a "top pick "because of its exposure to "early-cycle" business that will improve as the economy repairs, like consumer debt.
She also expects the bank to "emerge as a dominant player" in not only U.S. retail banking, but international investment banking because of its Merrill Lynch acquisition, and mortgage servicing. Graseck thinks charge-offs will begin falling in the next few quarters and foresees a peak in non-performing assets in the first half of 2010.
Still, Graseck acknowledges the fear that permeates the market related to regulatory reform, as well as Bank of America's leadership team, which was once again reshuffled this week by new CEO Brian Moynihan.
"Options are an attractive way to limit downside exposure given macro risks, the end of Fed easing, debate over financial services regulation, and new management," the analyst says.
Written by Michael Baron and Lauren Tara LaCapra in New York