Options Update: Wells Fargo Put Volume Surges Following Wall Street Speculation

It's no secret that the financial sector has seen better days. The laundry list of problems includes the credit crisis, subprime lending, Alt-A lending, CDOs, and auction-rate securities, just to name a few. Write-downs in the sector have been massive, and ever since the failure of Bear Stearns, Wall Street has been looking for the next company to go under. Judging by recent put activity on mortgage-banking and consumer-financial products specialist Wells Fargo (WFC | Quote | Chart | News | PowerRating), you'd think that investors are betting WFC will be next.

Possibly taking their cues from a recent Wall Street Journal article which questioned Wells' balance sheet and valuation, options traders have sent more than 49,000 puts across the tape so far today. The activity more than doubled the stock's average daily put volume, placing WFC on our Intraday Volume Explosion List. However, it was the 30,000 puts that traded at the WFC October 17.50 strike that caught my eye today.

Put Selling, or Put Buying?

There is a time for selling puts, and there is a time for gathering puts together. The question before us today is "Which season are options traders preparing for?" Looking at the chart below of WFC's notable October 17.50 call (WFC VT) block contracts, it would appear that put buying is the flavor of choice this week. Recent data from the International Securities Exchange supports this assumption, as some 62,556 put options have been purchased on the exchange during the past 10 trading sessions. Unfortunately, the 2 biggest blocks traded between the bid and ask price, leaving our "to buy, or sell" question without a clear answer.

For the sake of argument, let's look at both sides of this question. Taking the block of 10,000 contracts that crossed between the bid and ask at 10:28 a.m. Eastern time, let's first speculate that these contracts were purchased. The total outlay for the position would be $240,000, or ($0.24 * 100)*10,000 = $240,000. For this trade to reach breakeven, WFC would need to fall roughly 65% to $17.26 per share. We arrive at this by subtracting the cost of the option ($0.24) from the strike of the purchased put 17.50 ($17.50 - $0.24 = $17.26). That's a pretty sizeable plunge for WFC, and the shares would have to reach the 17.26 level before the options expired on October 17.

Taking the same block of 10,000 contracts, let's see what the trade would look like if we sold these October 17.50 put options. First, by selling these options, we need WFC to stay above the 17.50 strike by the close of trading on October 17, thus allowing us to keep all premium received for the position. To arrive at that premium, we basically perform the same task as above, multiplying the cost of the option by 100 contracts, and then multiplying that figure by 10,000. The resulting premium received for the transaction would be $240,000 - all of which we would keep, as long as WFC held above the 17.50 level by expiration. (Keep in mind that these put-selling calculations do not take into account any potential margin-account requirements enforced by your broker.)

So, with 2 paths laid out before us, let's see if the stock's technical picture or sentiment backdrop offer up any clues on which would be the more profitable position...

Technically Speaking

Like most financial sector stocks, WFC has been quite beaten up during the past several months. However, the security held up remarkably well versus the rest of the market, despite this volatility. In fact, WFC has outperformed the S&P 500 Index (SPX) during the past 40 trading days by more than 14%. The stock is also sitting on a year-to-date loss of just 7.9%, compared to the SPX's loss of more than 13.7%.

Meanwhile, the equity has rallied more than 39% from its July 17 lows near the 20 level. In the process, WFC has also reclaimed key long-term support at the 27 level. The potential for short-term resistance lingers overhead in the 32 region, but the shares could rally more than 10% before encountering this level. It's looking like our purchased put position is becoming more and more unlikely by the moment, given the improving technical situation for WFC. Advantage: put sell.

The Sentiment Drivers

On the sentiment front, expectations are par for the course with WFC. Options players clearly have a preference for puts over calls, with the stock's Schaeffer's put/call open interest ratio (SOIR) of 2.93 indicating that puts nearly triple calls among near-term options. What's more, this ratio ranks just 3 percentage points shy of an annual peak for WFC, meaning that traders have been more pessimistic only 3% of the time in the past year. Advantage: put sell.

Meanwhile, Wall Street is also extremely dour on WFC. According to Zacks.com, 11 of the 15 analysts following the shares rate them a "hold" or worse. Any positive news from WFC in the midst of the financial morass on Wall Street could certainly shock the brokerage bunch into offering an upgrade or 2. Meanwhile, the risk of downgrades is mitigated since most of the Street is already heavily negative on the shares. Advantage: put sell.

There is one final point I would be remiss in considering with WFC. The company expected to release its next quarterly earnings report on or near October 16. While the date has yet to be confirmed, anyone trading October options (which expire on October 17) will want to keep a close eye on expectations for this report. Currently, the consensus is expecting a profit of 49 cents per share from WFC. Historically, the company has beaten expectations twice, and missed twice during the prior 4 reporting periods, for an average upside surprise of 2.4%. From our "put buy" or "put sell" standpoint, we gain nothing on a rally in the shares due to a better-than-expected report, while a negative report could potentially provide the catalyst needed to place the purchased put in the money. Advantage: put buy.

The Verdict?

Looking at the data above, a put buy position looks extremely risky at the moment. While there is certainly the potential for WFC to announce some massive write-off or quarterly loss, will it really be big enough (in a market that has already seen so much from the financial sector) to sink the shares more than 65%? Meanwhile, for the put sell position, all WFC needs to do is not fall below 17.50 by the middle of October. Given the technical and sentiment picture above, a put sell seems the most profitable trading option - and maybe even a bit on the conservative side, given the upside bias of our sentiment indicators and the stock's technical performance.

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