Problems Mount for This Troubled Bank
The term troubled bank has become nearly synonymous with Wells Fargo & Co (NYSE: WFC). Recently the company reported earnings and as Reuters reported, traders seemed disappointed by the news as they appeared to sell the news.
News reports indicated “the bank dialed back its net interest income outlook for this year and reported a decline in total quarterly revenue.
The Federal Reserve has signaled it is unlikely to raise interest rates in 2019 given risks to the U.S. economy from a global slowdown, which investors have feared could pressure net interest income, or the difference between what a bank earns on loans and pays on deposits.
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The lowered outlook comes at a time of uncertainty for the fourth-largest U.S. lender following the abrupt departure of former Chief Executive Tim Sloan last month.
The bank has been working to keep a tight grip on costs as it continues to battle the fallout from a wide-ranging sales practices scandal that first erupted in 2016, efforts that helped profit rise in the first quarter even as revenue slipped.
Interim CEO Allen Parker said on Friday he was working on improving relations with regulators and making the bank more efficient but acknowledged “we have more work ahead of us.”
On a call to discuss the results, analysts repeatedly asked why the bank was lowering its net interest income outlook while peers remained more optimistic, and for details on how non-interest-related revenues from fees would shape up.
“If the revenue base keeps splitting down, I’m afraid that some of your loyal shareholders are going to start to exit before you have a new leadership in place,” Bank of America analyst Erika Najarian said.
Parker said Wells Fargo’s board is pressing forward with the CEO search, but has “complete confidence” with current leadership. He did not give a timetable for when a new CEO might be announced.
Finance chief John Shrewsberry reaffirmed that the lender was on track to hit its 2019 cost target. But the longer-term outlook is less certain, since the bank suspended its expense targets for 2020 after Sloan’s exit.”
These developments come with the stock trading at the lower end of a trading range that days back to 2017. A break of support could send the stock price significantly lower and that creates opportunities for traders.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in WFC
For WFC, we could sell a May 17 $45 call for about $1.95 and buy a May 17 $47.50 call for about $0.64. This trade generates a credit of $1.31, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $131. The credit received when the trade is opened, $131 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $119. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($131).
This trade offers a potential return of about 110% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if WFC is below $45 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $119 for this trade in WFC.