Thursday, April 23, 2009

Zen and the Art of Bank of America Options

Posted in the Wall Street Journal MarketBeat by David Gaffen:

Action in the options market is starting to suggest, however faintly, that some investors are starting to become concerned about the possibility that the government will have to do to Bank of America what it did to Citigroup – convert its preferred stake into common shares.

The implied cost to borrow Bank of America’s shares, calculated by looking at the activity in the options market, has increased of late, according to a derivatives strategy report from Credit Suisse. This would reflect a fear that the stock, at some point, will become difficult to borrow in order to sell short, which is what happened with Citigroup after the government announced plans to convert its preferred stake to common shares.

According to Sveinn Palsson, a derivatives strategist at Credit Suisse, the implied cost to borrow Bank of America shares has increased to about 55 cents out to November, compared with a “regular market rate” of about 20 basis points (of notional) overnight. Here’s the thing – at the end of March, just 2.4% of the outstanding shares of Bank of America were being sold short, nowhere near the 23% short interest that Citigroup experienced after the government announced its conversion plans. So it’s not as if the stock is hard to borrow at this point.

The Citigroup conversion motivated investment managers to put on a trade in an effort to capture upside when the preferred shares were converted to common stock. They were shorting the common shares and buying preferred en masse.

So many investors entered into this trade that the stock became hard to borrow, causing the borrowing cost to spike, and instead, investors resorted to using the options market to create what’s known as a “synthetic” short position. (This is constructed by selling a call option, buying a put option, and buying the stock.) Later on, delays and worries that the conversion would not happen caused a short squeeze, as the stock spiked, making the trade a money-loser for many hedge funds.

Such activity can be seen in Bank of America, where more than 30,000 call options and 30,000 put options expiring in August, with a $10 strike price, changed hands Thursday. “It could be somebody setting themselves up to not be in a position to scramble to pay 60 to 80 cents to borrow like Citigroup,” says Jon Najarian, co-founder of That strike price has become a popular one, as open interest in the calls totaled 110,000 prior to Thursday’s action.

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