On September 19, a significant volume of call options on Bank of America Corp (NYSE:BAC) was traded, catching the attention of investors. These calls, situated deep in-the-money, signal a bullish sentiment and suggest that investors foresee potential upside in Bank of America stock.
There were 25,500 contracts traded for call options with a strike price of $24.00, set to expire in 30 days on October 20, 2023. Notably, the volume of these calls traded was 215 times higher than the usual volume of outstanding call options, indicating substantial interest.
This surge in call options trading implies the involvement of a large institutional buyer or a group of buyers who express confidence in Bank of America and its future prospects. One reason behind this confidence could be the belief that a recession is not imminent. Additionally, if interest rate hikes are approaching their peak, it could bode well for the bank’s long-term profitability.
Exploring the Rationale Behind Buying In-The-Money (ITM) Calls
To understand the rationale for a large fund buying in-the-money (ITM) call options, let’s delve into the numbers. The premium of $4.82 added to the $24.00 strike price results in a total cost of $28.82 per call option. On September 19, the stock closed at $28.65.
This means that purchasing these 30-day calls involves paying slightly more than the current stock price. Specifically, there is 17 cents of extrinsic value, accounting for just 3.66% of leverage (i.e., $0.17/$4.65) beyond the intrinsic value of the call options.
It’s important to note that the fund(s) paid $4.82 for each call, yet these calls are worth $4.65 per contract. Therefore, if BAC’s stock were to reach $30 on or before October 20, the calls would likely be valued at more than $6.00 (i.e., $30 – $24 strike price). For instance, at a price of $6.17, the fund would gain 28% in just 30 days (i.e., $6.17/$4.82 – 1).
This potential gain far surpasses the 4.7% return one would achieve by buying and holding BAC stock, assuming it increased from $28.65 to $30 per share. Moreover, the fund can acquire nearly six times more call options compared to holding equity (i.e., $28.65/$4.82 ≈ 5.94x).
In summary, this leveraged approach makes sense if the fund anticipates an upside potential in BAC stock and believes in the bank’s underlying fundamentals.
Bank of America Stock’s Attractive Valuation
One of the motivating factors for the fund’s purchase of ITM calls may be Bank of America’s compelling valuation. Based on analysts’ forecasts, the stock is trading at just 8.48 times earnings for 2023 and 8.85 times earnings for 2024.
This valuation is notably below its historical 11.83x price-to-earnings (P/E) average over the past five years, as reported by Seeking Alpha. Similarly, Morningstar cites a historical five-year P/E average of 11.62x.
This suggests that BAC’s stock could potentially rise by 38% if it were to return to its historical average P/E multiple, setting a target price at $39.54 per share.
Furthermore, Bank of America pays an annual dividend of 96 cents, resulting in a dividend yield of 3.35% at the current stock price of $28.65 per share. Importantly, the bank has consistently raised its dividend for the past nine years.
Additionally, Morningstar reports a historical five-year average dividend yield of 2.28%. If BAC’s stock were to trade at this yield, its price would need to rise to $42.11, reflecting a 47% gain from its current level. This calculation is based on dividing the 96-cent annual dividend by 0.0228.
Finally, BAC’s stock is trading at 0.89 times its book value of $32.05 per share (i.e., $28.65/$32.00). In contrast, its historical average price-to-book value (P/BV) has been 1.13x, as indicated by Morningstar. This suggests a 27% upside (i.e., 1.13x/0.89x) in BAC’s stock, bringing it to $36.39 per share.
Considering these three price targets derived from historical P/E ($39.54), dividend yield ($42.11), and P/BV ($36.39), the average of these targets amounts to $39.35 per share, representing a 37% increase from the current price.
It is likely that the funds purchased a substantial number of in-the-money call options in Bank of America stock due to its attractive undervaluation based on these metrics.
Featured Image: Unsplash @ Rubaitul Azad
