A large volume of call options traded on Tuesday, Sept. 19 in Bank of America Corp (BAC) stock. The calls were deep "in-the-money" and indicated that investors believe in upside in BAC stock.
A report from Barchart shows that there were 25,500 contracts traded in the $24.00 strike price call options that expire in 30 days on Oct. 20, 2023. The Barchart Unusual Stock Options Activity Report on Sept. 19 showed that the volume of calls traded was 215 times the normal amount of call options outstanding.
This implies that a large institutional buyer or a set of buyers likely bought these call options. They obviously believe in the upside in Bank of America and its stock.
One reason is they don't expect a recession in the near future. Moreover, if interest rate hikes are close to their peak that could be good for the long-term profitability of the bank.
Buying In-the-Money (ITM) Calls
Let's look at the arithmetic of why a large fund would buy in-the-money (ITM) call options. First, note that the premium of $4.82 added to the $24.00 strike price equals $28.82. The stock closed at $28.65 on Sept. 19.
So, that means buying the 30-day calls involves paying slightly more than the spot price. For example $28.82 - $28.65 leaves 17 cents of extrinsic value, or just 3.66% of leverage (i.e., $0.17/$4.65) over the intrinsic value of the call options.
Remember the fund(s) paid just $4.82 for the calls, but they are worth just $4.65 per call contract. So, for example, if BAC stock rises to $30 on or before Oct. 20, the calls will likely rise to more than just $6.00 (i.e., $30- $24 strike price). At $6.17 for example, the fund will make a gain of 28% in 30 days (i.e., $6.17/$4.82-1).
This would far exceed the 4.7% gain buying and holding BAC stock if it rose from $28.65 to $30 per share. Moreover, the fund can buy almost 6x more call options than holding equity (i.e., $28.65/$4.82 = =5.94x).
The bottom line is that this leverage effect works if the funds see a potential upside in BAC stock and the underlying bank's fundamentals.
BAC Stock Looks Inexpensive
One reason the fund might be willing to buy these ITM calls is that BAC stock looks like a good bargain here. For example, based on analysts' forecasts the stock trades for just 8.48x earnings for 2023 and 8.85x earnings for 2024.
This is well below its 11.83x historical price-to-earnings (P/E) average over the past 5 years, according to Seeking Alpha. Similarly, Morningstar says the historical 5-year P/E average is 11.62x.
This implies that BAC stock could rise 38% if all it did was return to its historic average P/E multiple. That puts its target price at $39.54 per share.
In addition, Bank of America pays an annual dividend of 96 cents, giving the stock, at $28.65 per share, a dividend yield of 3.35%. In addition, the Bank has consistently raised its dividend over the last 9 years.
Moreover, Morningstar reports its historical 5-year average dividend yield has been 2.28%. So, if BAC stock were to trade at this yield the stock price would have to rise to $42.11, a gain of 47% from here. This is calculated by dividing the 96-cent annual dividend by 0.0228.
Lastly, BAC stock trades for 0.89 times its $32.05 per share book value (i.e., $28.65/$32.00). By contrast, its historical P/BV average has been 1.13x, according to Morningstar. That implies a 27% upside (i.e., 1.13x/0.89x) in BAC stock to $36.39 per share.
So, we have 3 price targets based on historical P/E ($39.54), dividend yield ($42.11), and P/BV ($36.39). The average of these three price targets is $39.35 per share or 37% over today's price.
This is likely why the funds bought so many in-the-money call options in BAC stock, given how undervalued it is now.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
