Tuesday, August 30, 2011

OPTION PRICING BAC

   I want to follow up on the Warren Buffett/Bank of America trade. The announcement came as the market was about to open. Within seconds the stock shot up, but very quickly it backed off. But very quickly after this open, the options seemed stuck. In fact, later, with the stock at the mid $7.50 range, there were some crazy prices coming out of the option guys. That is what I'd like to comment on.
In general, when there is a gap up or down, meaning the stock (especially at the open) trades significantly higher or lower, it takes awhile for the option market makers to settle in. It's called going through rotation. In fact, the option market opens a few minutes after the stock market opens, giving the market makers time to adjust, catch their breath, and adjust their prices, coming from their computer models.
   Just think of the complexity of this. Bank of America for example: It has $1 incremental strike prices---say the 3, 4, 5, 6, 7, 8 dollar calls and many more----for September. It has puts to adjust as well. Now go to the October option strike prices and all other months out for about nine months. Add in two years of the January Leaps (R), and you have a computer running fast and hard. In three more seconds, the stock is up 10 cents, and all of those prices have to adjust again. This goes on all day. Now imagine doing this, even with the fastest computers, while trading---rapid and heavy---is also occuring. It can boggle the mind, especially a mind so finite as mine.
   So what would you do? If I were a market maker I'd stop trading for awhile. Let it go through its rotation and settle down.
   Here's an example: Bank of America stock was at $7.67. The $7 call would be 75 cents to $1 or so. The $8 call would be 30 or 40 cents. Now the price includes the in-the-money portion, time to expiration, but other components of their formulas. Not so this time. The $7 calls were going for 57 X 60 cents. That's not even representative of the in-the-money portion of 67 cents. It tells me the market is locked, meaning not active.
   And what about the $8 calls? I thought you'd never ask. They were trading (NOT) at 0 X .01 cents. That confirmend to me that the trading was stopped.
   Later in the day, when the big runoff was over, the stock was still at $7.76. The $7 calls were $1.03 X $1.05. The $8 calls were going for 44 X 45 cents. The spread between the bid and ask also tightened up, showing more confidence by the option market makers.
   So, in closing, let's look at this stock as a covered call possibility:
1) We'll buy 1,000 shares of stock at $7.76, or $7,760---or half of that on margin. Now sell 10 contracts (representing our 1,000 shares) for $1.03. That's $1,030. Yes we'd have to give back 76 cents, or $760 if called out, but that is not bad.
2) Now, let's look at the $8 call. If you bought the stock and sold this strike price, it would look like this, You would have the same cash into the stock. Now, sell the $8 call for 44 cents, and take in $440. Someone now has the right to buy your stock, anytime on or before the third Friday of September for $8. If they were to do so, you would take in $8,000. That's $240 more than you paid for it and you also get to keep the option premium of $440.
A couple of quick points: a. make sure you protect the downside movement of the stock. Maybe put in a stop-loss at $6.90 to $7.20---whatever makes you happy and secure. b. By selling the out-of-the money (actually either of them) you can always buy-back the option, meaning you would end the obligation to deliver the stock at one of the two prices. On the next rise in the stock price, you could sell it again, or even sell the October's. This way, you're selling more time, and putting more cash into your account. You can pull out this received option premium anytime you want to.
   Tomorrow and this week, I think we'll see some good movements in the market. August is one of the three most down months in the market, but the last week has been kind for many years. It's funny, because so many brokers go on vacation, but oftentimes (like the day after Thanksgiving, the day before Christmas, or even Friday before Easter and others), the market rises on light volume. It doesn't make sense, but there you go.
   As we get ready to post this blog entry, BAC stock is at $8.19. The $8 calls are going for .56 x .57. These prices are all snapshots in time. Be sure to do your own homework and consult your financial professionals before entering into any trades.
Have a great week. Watch and learn to connect the dots.
I standby ready to help.
Wade

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