Options Strategies for Wells Fargo

Financials, specifically banks have been an under-performing sector for the last few years. Most Investment banks have been hit by regulatory blows as well as macro-economic headwinds. In many cases, tangible book value has not provided a floor for stock prices. Nevertheless, Wells Fargo has been able to sustain the headwinds. As more banks release their quarterly results later this week, the future of the industry remains clouded with uncertainty. Much is unknown about the future path of regulation, and debt exposure. Even internal operations have created many surprises such as the JPMorgan trading loss and the Barclays Libor scandal. As well, the low interest rate environment has caused interest margin contraction. The deployment of increased liquidity into lower-yielding securities has squeezed bank profits. Moreover, low interest rates have caused investors wanting higher yields to seek new investments. Share valuations indicate a preference away from the largest banks. For example, JPMorgan Chase

trades less than seven times consensus 2013 EPS estimates and just above its tangible book value. Bank of America

shares trade for only 0.6 times tangible book value. In contrast, Wells Fargo

trades at 2.1 times tangible book value. Wells Fargo has much stronger and more consistent returns than the other large banks. Wells Fargo has returned over 23% year to date. Wells Fargo reported financial results from its second quarter operations July 13th which consisted of record net income and earnings per share. After Wells Fargo's financial results, investors may wish to re-examine the bank's strengths, weaknesses, opportunities, and threats. Diluted earnings per share was 0.82, in line with expectations. The tier 1 Common equity ratio has continued to improve and net interest income remained the same as last quarter at 3.91%. Moreover, less than 10% of reported earnings came from released loan loss provisions. In comparison, 40% of earnings from JPMorgan Chase came from loan loss provision releases. Financial troubles, especially in Europe may present opportunities for Wells Fargo as banks sell valuable assets to raise capital. In the quarter, Wells Fargo acquired BNP Paribas' North American energy lending business. Wells Fargo's earnings come from stable businesses such as retail and commercial lending and asset management. Moreover, the bank is not exposed to volatile investment banking earnings as much as the other major institutions. Investors who believe that Wells Fargo represents a strong long term investment may consider using options to invest. Especially since options on Wells Fargo exhibit a strong reverse vertical skew. Moreover, implied volatility increases for longer-dated expirations, demonstrating a horizontal volatility skew. When examining options with January 19th, 2013 expiration, investors would notice that at the money options trade with roughly a 27% implied volatility. Options with strike prices 25% below the current price of $34.04 a share, trade with an implied volatility of 34%. This demonstrates the reverse volatility skew. There are several strategies for both the cautious investor and the more aggressive investor. To take advantage of the volatility skews apparent in options on Wells Fargo, cautious investors may wish to implement a ratio spread strategy. A ratio spread involves buying some options and selling a different number of options on the same underlying security. Investors should consider selling and buying put options with January 19th, 2013 expiration. Investors may wish to sell 24 puts with a strike price of 21.0 as these options have an implied volatility of 43%. Each sold put would result in a net credit of .20. Investors may also wish to purchase a put with a strike price of 34, with an implied volatility of roughly 27% for a debit of 2.79. The 24-to-1 ratio spread results in a net credit of 2.01 or $201. For the trade to be executed, the investor will need to set aside funds as margin. Reg-T margin requirements for selling a naked put on a stock at professional discount brokers such as Interactive Brokers is the put ask price plus the greater of 20% of the Underlying price minus any out of the money amount or 10% of the strike price. Put Price + Maximum [(20% * Underlying Price - Out of the Money Amount), (10% * Strike Price)] Each put being sold in the 24-to-1 ratio spread strategy has a margin of $232. When multiplied by 24, the margin needed for the option selling portion of the strategy is $5568. The purchased put option costs $279. Therefore the total funds needed to be set aside are $5847. The funds used for the strategy could be used to purchase roughly 171 shares of Wells Fargo. In this conservative strategy, profit actually increases if Wells Fargo depreciates in value at expiration to a certain point. Max profit of $1478 occurs if shares of Wells Fargo decline to $20.99. Although margin requirements may change if Wells Fargo shares decline, assuming constant margin requirements until expiration, at max profit the return to expiration is 25.3%. When annualized the return is 55.7%. The ratio strategy breaks-even if shares of Wells Fargo depreciate to $20. This would represent a decline of 41.2% in 179 days. The strategy would therefore breakeven unless Wells Fargo exhibits a drastic fundamental change with its relatively safe business model or the United States goes into a severe recession. Profit is capped at $34 a share. Profit is the net credit received when the trade was initiated. If Wells Fargo trades above $34 a share at expiration, assuming constant margin requirements, the return to expiration would be 3.44%. When annualized the return is 6.86%. For investors who want to invest more, the ratio spread strategy is easily scalable. For example, multiples of this ratio include 48-to-2 and 72-to-3. The ratio spread strategy is for more risk adverse investors who are willing to limit their returns on the upside for less downside risk. More aggressive investors who believe Wells Fargo will remain strong for the next several months may wish to sell naked puts expiring January 19th, 2013. A couple of naked put strategies investors may wish to consider will be described below. Investors may want to sell the 17.5 strike price put for a credit of 0.10 or $10. This put has an implied volatility of 49%. The margin requirement for the transaction using the same margin requirement formula described above is $187. Max profit is achieved if shares of Wells Fargo are greater than $17.5. The breakeven point is $17.4. To reach the breakeven point shares must decrease in value by 48.5%. Assuming no changes in margin requirements and shares are valued greater than $17.5, the return to expiration for this naked put strategy is 5.2%. When annualized, the return is 10.5%. Even more aggressive investors may wish to sell a put with a higher strike price. Selling a put with the same expiration date, with a strike price of 22.5 for a credit of .28 can be lucrative. The put has an implied volatility of 39.5%. The margin requirement for selling the naked put is $256. The breakeven point is $22.22. Max profit occurs if shares are valued greater than $22.5 at expiration. Assuming no changes in margin requirements, the return to expiration would be 10.8%. When annualized, the return is 22.4%. Wells Fargo trades at a premium to tangible book value because the business is insulated from much of the volatile investment banking earnings and instead is exposed to more stable financial services such as retail and commercial lending. Instead of purchasing shares of Wells Fargo, more cautious investors may implement the ratio spread strategy, while more aggressive investors may decide to sell naked puts.