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Wells Fargo Might Not Be an Investment, But It Is Tradable

Wells Fargo Might Not Be an Investment, But It Is Tradable

There are many ways to distinguish investment opportunities from trading opportunities. One is the time frame. An investment will be something an investor expects to hold for an extended period of time. A trade will generally be something that will be bought with the intention of earning a short term profit.

Related to that difference is the degree of safety in the investment. Many large companies are relatively stable and they can usually be considered to be safe investments. A trading opportunity will generally carry an element of risk that makes the long term almost impossible to anticipate.

There are times when large companies become risky. This has been the case with Wells Fargo & Company (NYSE: WFC) over the past couple of years. In 2016, the company reported that under the pressure of sales quota, employees created millions of fake accounts.

The News Continues to Deliver Scandals

Since then, there has been a steady drip of bad news from the company as regulators impose fines for the fake accounts and a variety of other actions the company took over the years.

After the initial scandal, the bank uncovered a number of incidents regulators and investors find troubling. Recently, the California State Treasurer extended a ban on the state’s business with Wells Fargo citing “a string of new disclosures about problems at the bank.”

In his statement, California Treasurer John Chiang  noted there was an “infestation of problems” that “have come scurrying out of dark corners within Wells Fargo,” and specifically identified several of the problems:

  • The number of phony accounts has ballooned from an initial 2 million to now 3.5 million.
  • This past July, news broke that as many as 800,000 consumers were forced by the bank to buy “lender -based” car insurance they did not need, tipping a quarter of a million Wells Fargo customers into delinquency and triggering 25,000 vehicle repossessions.
  • In August, a new and different auto insurance fraud scandal broke in which the bank is being accused of failing to make refunds to consumers who paid off their loans early.
  • Also in August, Wells Fargo agreed to pay $108 million to settle a lawsuit claiming it overcharged military veterans under a federal mortgage refinancing program.

News reports added:

“As revelations like these are recurring “with such regularity,” Americans could “become de-sensitized to the bank’s pervasive exploitation of the public’s trust.” He added, “It concerns me when systemic fraud and abusive banking practices are broadly viewed as the new normal.””

The stock initially sold off on the news of the scandal but then moved to new highs as traders seemed to believe the end of the bank’s problems was near.

Wells Fargo Might Not Be an Investment, But It Is Tradable

But, the Bank Disappointed Investors, Again

Last week, The Wall Street Journal reported that US regulators are now examining practices in the investment banking business and the four individuals were fired for cause. The newspaper said it wasn’t clear what issues were being probed and didn’t name the regulator involved.

At least one large investor expects even more. Steve Eisman, a fund manager at Neuberger Berman famous for shorting the housing market before the bubble burst, recently spoke at a conference and said he is now betting that Wells Fargo shares will decline.

“The cultural issues I think at Wells Fargo went very, very deep,” Eisman told CNBC in a recent interview. “They have to unwind these cultural issues.” Eisman expects earnings will be “flattish” over the next few years, and pointed to negative signs such as the bank’s decline in loans in the third quarter.

Eisman could be right and the stock could be among the biggest losers in the financial sector. What seems likely is that traders will be waiting for news from the bank to determine how this latest scandal will affect earnings and the share price.

For now, it seems that traders seeking to establish a position in Wells Fargo should focus on risk. The stock is likely to fall into a short term trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.

To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.

In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.

The risks and potential rewards of the strategy are shown in the following diagram.

Wells Fargo Might Not Be an Investment, But It Is Tradable

Source: The Options Industry Council

The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.

Opening an Iron Condor in Wells Fargo

For WFC, the trade can be opened using the following four options contracts:

Opening an Iron Condor in Wells Fargo

As you see, all of the options expire on the same day, Friday, November 17.

The difference in the exercise prices of the calls or puts is equal to $2.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $200 less the premium received when the trade was opened.

Selling the options will generate $0.41 in income ($0.21 from the call and $0.20 from the put). Buying the options will cost $0.15 ($0.08 for the call and $0.07 for the put). This means opening the trade will result in a credit of $0.26, or $26 for each contract since each contract covers 100 shares.

The maximum risk on the trade is equal to the difference in strike prices ($2.00) minus the premium received ($0.26). This is equal to $1.74, or $174 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $174 in capital.

The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.26, or $26 per contract.

The potential reward on the trade ($26) is 9% of the amount risked, a high potential return on investment for a trade that will be open for less than a month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.

The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.

These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.