A Low-Risk Strategy to Make a Wells Fargo Entry

It is possible to safely buy into Wells Fargo now, despite its recent troubles, using married puts

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Oct 05, 2016
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Since news about false bank and credit card accounts surfaced in early September, Wells Fargo & Co. (WFC, Financial) has taken a very big reputational hit. That hit included a fine of $185 million. In addition, it says it fired some 5,300 employees, who presumably will need to be replaced, thus incurring recruiting and training costs, as well as foregone revenue until the new employees get up to speed.

The already-depressed share price fell off even more, as this 1-year chart shows:

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With that, value-seeking investors may wonder if they should get in at this price, which (at the close of trading on Tuesday, Oct. 4) is 20% off the 52-week high of $55.04. Headline writers at TheStreet.com went so far as to call Wells Fargo, “A Superb Contrarian Play Now."

We won’t debate the question of value, or relative value, in this article, but will look at using stock options to protect an entry position. The objective is to minimize the risk involved in buying the stock, should it plunge even lower.

Put options

A put option resembles auto or homeowners’ insurance, as I’ve explained in several articles, including Lower or Eliminate Risk in a Volatile Value Stock: Herbalife Case Study. Simply explained, you pay a premium and in return receive protection against a loss.

If you buy a put option after you buy the stock, it’s called a protective put; on the other hand, when you buy the stock and put option together (in one transaction), you have a married put. Married puts and protective puts function the same way once they’re placed.

Since we’re assuming a Wells Fargo entry now, we’ll also assume buying a put at the same time, making this a married put situation.

All stock options, whether puts or calls, are bought and sold in contracts of 100 units, matching 100 shares of stock. In this article, we’ll assume the purchase of 100 shares of stock and one contract of put options. For convenience, we will assume the transaction cost of buying one put contract at $10; your costs could well vary (we won’t include stock transaction costs, as that’s a given whether you buy puts or not).

What will protection cost?

The following image shows an excerpt from the put options chain (table) for the Jan. 20, 2017 expiry at Yahoo Finance:

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  • The numbers on the left side show the option strikes, in dollars (the stock price at closing on Oct. 4 was $43.75);
  • The combination of letters and numbers in the second column show each expiry’s unique identifier;
  • In the third column, we see the last price paid on Oct. 4 (but we are not told whether that was a buy or a sell);
  • Column 4 (starting with 1.48) shows the Bid price, which is normally what we pay when we sell an option;
  • The fifth column shows the Ask price, what we usually pay when we buy an option—that’s what we’ll focus on in this article.

Which option should I choose?

As is almost always the case with investing, we need to consider tradeoffs. A higher strike price provides more protection, but also costs more up front.

We will only know, with certainty, which strike price is best after the fact. If the stock price is higher at the option expiry than at the time of purchase, then a lower strike would be best. On the other hand, a higher strike will return more if the price of the stock drops from its current level, before expiration.

We can clarify the choices and results in a table like this (data at the close of trading on Tuesday, Oct. 4):

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The table shows us that buying $42-strike put options would increase our initial cost by 3.38%, and our potential loss could reach 7.16% in the worst case scenario.

At the other end, a $45-strike put would increase our initial cost by 6.56%, but in the event Wells Fargo’s price keeps falling, our loss (again in a worst-case scenario) would be just 3.5%.

We will all have our own preferences, based on our risk tolerances and our investing objectives.

Keep in mind this table shows only the nearest strikes to the current price, for the expiry date of January 2017; many other strikes and expiry dates are available as well.

Next, let’s review the probabilities of Wells Fargo’s price being below certain strike prices at expiry on Jan. 20, 2017. To do that, we use the TradeKing/iVolatility Probability Calculator:

02May2017151948.jpg

The calculator shows us a 26% probability that the price of Wells Fargo shares will be below $40.00 on Jan. 20, 2017, and by inference, a 49% probability the price will be below $43 on the expiry date. Note use of the word probability; these are not guaranteed outcomes.

The market’s current sentiment, then, is that while there are roughly equal odds the price will be lower at expiry, it doesn’t think it too likely a slide, if there is one, would continue past $40.00.

No definitive reading, but we have a modest thesis that Wells Fargo’s stock price may have bottomed out, or is close to bottoming out.

Conclusion

If you believe Wells Fargo is a good investment, despite its recent troubles, then you can buy in, and buy in with minimal risk.

The key is to use put options in the same way you use auto insurance and home insurance. You spend a small amount to pass along most of the risk to another party; in this case, you transfer it to an option seller.

As we’ve seen, we have many choices; we can buy puts with stock to create a married put or we can buy puts some time after buying the stocks to create a protective put.

We also saw that we have choices as to how much risk we want to transfer away, in the same way we select different deductibles on our car insurance. Pay more for less risk, pay less for more risk. Personally, if I were buying puts in this situation, I’d likely opt for the lower strike option, since the downside risk doesn’t appear as great as it did a few weeks ago. You would make your strike decision based on your own risk tolerance and investing goals.

But don’t let the cluster of tactical choices obscure the strategic choice: to protect or not protect your investment with put options. That’s the crucial first decision and one well worth considering carefully before buying any stock, but particularly a stock that has run into serious problems in the recent past.

Disclosure: I do not own stock or options in any of the companies listed in this article, nor do I expect to buy any in the foreseeable future.

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