The current ratio of calls to puts on BAC and CITI implies buying BAC and other banks may be profitable in the short run. One of the cues that investors can use in picking stocks for short term investment is activity in the options market. Although calls on CITI outnumbered puts by one and a half to one the call to put ratio of Bank of America – BAC, was closer to five to one. This ratio implies that options traders are expecting the price of the bank stocks to go up. Rather than buying BAC and other bank stocks, options buyers simply purchase a contract which gives them the right to buy the stock, in the case of a call, or sell the stock, in the case of a put, on or before the expiration of the options contract. Because standard options contracts only run for a few months options traders typically do not deal with a longer time horizon. Anyone buying BAC and other bank stocks based on the current put to call ratio need to keep this fact firmly in mind. Following the put to call ratio in the options market can be a good means of picking new winners but it does not tell the long term investor what the picture will be next year or in a decade.
Over the long term investors need to apply fundamental analysis to BAC and other bank stocks in order to decide if they are likely to be profitable over the years. One obvious factor is that these stocks have been beaten down during the recession and are suffering from other factors such as lawsuits by the US government regarding the nature of mortgages that they sold to Freddie MAC and Fannie MAE. If the economy does not right itself and things do badly for these banks they could go bankrupt, need to restructure, and become long term losing propositions. On the other hand the current dismal market may have underpriced these stocks. Thus, buying BAC and other bank stock in the short term could be profitable in the short term.
An alternative to using options as a cue to buying BAC and other bank stocks is to buy call options one’s self. Investors can purchase options on blocks of 100 stocks, pay the current price for the options contract, and the purchase the stock at a nice discount if goes up on price. Some of the best stock investment in a declining market can be scouted out by watching the options market. If an investor buys call options on a stock like BAC he only stands to lose the price of the options contract is the stock takes a nose dive. He is essentially taking out insurance against a fall in stock price. On the other hand, if the stock soars in price, he will execute the options contract and purchase the stock at the contract price, known as the strike price, no matter how high the price may have risen.