New Trade $WFC: Wells Fargo Centered

by Enis July 11, 2013 2:32 pm • Commentary

We previewed WFC earlier ahead of its earnings announcement tomorrow morning.  We were initially inclined to leave this one alone, but we were intrigued because of the big move in rates in the 2nd quarter.  We also settled on a lower-risk options structure.

My main takeaway for WFC that the stock has been a very consistent performer, but this earnings quarter is pivotal based on the huge move in rates we saw in the 2nd quarter.  The last 2 quarters where rates moved quickly higher were the first quarter of 2012 and the 4th quarter of 2010.  WFC was down after the earnings announcement after the stock rallied into the earnings announcement in both instances.

The velocity of the current move is larger than those prior 2 instances.  While there is a long-term benefit to higher rates from a net interest margin perspective, the short-term negative impact on Wells Fargo’s mortgage business could hurt this quarter and next quarter’s earnings.

Moreover, the technical setup shows a stock bottled between 40 and 43, that was unable to hold its new high on this week’s breakout.  With that in mind, here’s the trade:

Trade: WFC ($42.) Bought the July19th / Aug16th 41 Put Calendar for $0.49

-Sold 1 July19th 41 Put at .29

-Bought 1 Aug16th 41 Put for .78


The ideal spot for this stock at July expiration is 41, at which point the short July 41 put will be at zero and the Oct 41 put will still be bid. Before then the structure is slightly bearish with 41 still acting as the ideal spot, but even without much movement the structure will benefit from July decaying quickly after the earnings event.  The main risk is a move above 43 or below 39 on the event tomorrow.

Payout Diagram:

[caption id="attachment_27998" align="aligncenter" width="712"]Screen Shot 2013-07-11 at 12.20.29 PM from ThinkOrSwim[/caption]

Trade Rationale:  We chose the 41 strike because we view the history of WFC price action after rate rises as consistent with a pause here, especially given the run-up over the last 3 months.  However, the trade in the short-term is more focused on a small move after earnings than purely directional.



Original Post July 11, 2013 at 12:32pm:  $WFC Q2 Earnings Preview

Event: WFC reports Q2 earnings tomorrow before the open.  The options market is implying about a 2.75% move, which is higher than the 4 qtr avg move of 1.85%, and lower than the 8 qtr avg of about 4.5%.

Sentiment:  Wall Street has been fairly mixed on the stock for sometime, which is a bit surprising given its strong performance in the past 2 years (analysts usually followers of price).  There are 19 Buys, 21 Holds and only 2 Sells with an avg 12 month price target of ~$43, close to where the stock is currently trading.  Interestingly, the stock is slightly down this week despite the strong market move higher.

Options Open Interest:  Total open interest is slightly skewed towards puts with 650k to 550k in the calls.  The largest single open lines are more than 100k of the Jan14 30 puts and around 40k of the Jan14 40 calls.

Fundamentals:  Wells Fargo is the largest commercial bank in the U.S., focusing on classic bank lending activities for the bulk of its earnings.  It is heavily concentrated in the real estate market.  About half of its “Total Earning Assets” on its balance sheet (essentially all loans and securities) is composed of real estate related assets.

WFC has a consistent record of earnings growth given the staid nature of its lending business (with the exception of the financial crisis).  It is expected to earn $3.71 in the 2013 calendar year, for a P/E multiple around 11-12x. slightly lower than its 10 year average, and in line with its 5 year average.

The main concern for WFC is the rapid rise in rates.  While that’s a long-term benefit for future lending interest margins, in the short-term, that could impact the value of their current assets.  Here is the 30 year mortgage rate over the past 10 years:

30 year Fannie Mae fixed mortgage rate, Courtesy of Bloomberg
30 year Fannie Mae fixed mortgage rate, Courtesy of Bloomberg

So in the context of the past 10 years, rates are still low, but much higher than the past year.  The tradeoff for WFC is how much it is hurt by the drop in mortgage origination and refinancing volume vs. the future benefit of higher yields.

Price Action / Technicals:  WFC stock broke out to a new bull market high on Monday, though it has been met with some selling ever since.  A lot of congestion over the last 6 weeks:

1 year chart of WFC,  50 day ma in pink, 200 day ma in black, Courtesy of Bloomberg
1 year chart of WFC, 50 day ma in pink, 200 day ma in black, Courtesy of Bloomberg

The 40 level is the key spot, where the 50 day ma comes into play.  The recent high is around 43.  I don’t anticipate either of those levels breaking on earnings without a very surprising number from WFC.

Volatility Snapshot:  While implied volatility in WFC is close to where it has been ahead of prior earnings announcements, it is notable that realized volatility is near the highs of the past year.  General market volatility has increased the price movements in WFC, making selling options less attractive than normal ahead of earnings:

WFC 1 year chart of 30 day implied vol (red) vs. 30 day realized vol (blue), Courtesy of LiveVolPro
WFC 1 year chart of 30 day implied vol (red) vs. 30 day realized vol (blue), Courtesy of LiveVolPro

MY VIEW:  My initial inclination was to do a short vol trade as I expect WFC stock to remain between 40 and 43 for the next month, even with earnings.  However, I’m not likely to do anything because realized volatility has been higher than normal over the last month, so the risk/reward is less favorable.  On a fundamental basis, there is also some concern that the rise in rates might have disproportionately affected them this quarter, so I’m staying away.