Why is Bank of America (BAC) Volatility for Sale?

Unlike retail traders who typically bet on direction (whether the underlying will go higher or lower), most professionals don’t want to take too much of a directional guess (of course there are always exceptions). Thought it will depend from trade to trade, most professional traders prefer to make bets on volatility.

Intuitively, when you think about it, making a bet on the “price range” of a stock should be easier than making a bet on its specific direction. This is not without a caveat, as it’s not just the range of the stock, but how quickly it gets from point to point. At the end of the day, it can also be as simple for a trader as guessing the range by expiration; this can be done with long or short straddles or strangles.

Yesterday in Bank of America (BAC), we saw heavy options selling in the May months. May 20 calls were for sale (26,000 of them traded) and the May 15 straddle was also on the chopping block. The May 20 call trade makes some sense as financials are beginning to weaken after the strong rally we have seen over the past couple of months.

JP Morgan Chase (JPM) released a note indicating that major banks are scaling their lending activities to boost capital to cover credit losses. (Well duh, they can borrow from the FED for 0.25% and lend it right back to them at a guaranteed 3-3.25%, not too shabby). So things at the major banks might be fairly quiet (at least on the lending front) for some time.

But back to the 15 straddle that was sold; why someone would trade this straddle? In BAC, there was quite a bit of horizontal skew, or the difference in implied volatility going out in time. Think of it as an “options contango.”

December at-the-money implied volatility was around 37, while May volatility was above 47; that is a 27% difference in volatility, essentially meaning that fear was in the back months. In other words, the market is more afraid of BAC in April and May than before the new year. January and May are both the expiration months that include earnings and this could certainly be a reason for the elevated volatility. Regardless, traders still believe that it is too expensive.

The May 15 straddle traded for $4.12 or so, which means your breakeven in that trade is $4.12 in either direction, so if BAC stays between 20.02 and 11.78, the trade will be profitable. Considering the stock has been in that range since June, which it about six months, and has been moving at less than 40% volatility for the past 60 days, it would make sense that it may continue for the next six months … or does it?

The short straddle is certainly a risk proposition, with unlimited loss potential to the upside and in this case only $11.78 of risk to the downside. I am sure these traders weighed their risk carefully before executing, as should you.