Wells Fargo’s Troubles Create a Trade Opportunity

Banks are in trouble once again. This time, they face risk on multiple fronts. That’s according to Neil Barofsky, the Treasury Department Inspector General from 2008 to 2011. In other words, he was the man in charge of overseeing TARP – the controversial bailout of banks during the last financial crisis.

He told Yahoo Finance that the same banks that reaped the benefits last time around and were declared “too big to fail” in 2008 are once again at risk. They need to hold more capital than they do currently to prevent another round of problems. And that “If we have another crisis, there’s no question in my mind that we have to bail them out again.”

This is a pretty bleak outlook for anyone old enough to recall the devastation that followed the last liquidity problem at these banks. But, it is only one man’s word. So, is it really that bad?

Well, you may recall the story over Christmas last year about Treasury Secretary Steven Mnuchin.

He, for reasons only he knew at the time, called up the heads of many of the largest U.S. banks the weekend before Christmas to ask if they had enough liquidity to handle any sort of future credit crunch. At the time, that was a head scratcher.

Now, when combined with this latest revelation by the man who knows possibly more than any other how banks’ liquidity can become a real problem, we have to consider something bad going on.

Of course, this is only one front banks are dealing with. And the one with the most problems is Wells Fargo.

Just today, its CEO, Tim Sloan is in D.C. in an appearance in front of the House Financial Services Committee. He’s being grilled over his bank’s terrible recent history of crises and fraud.

The list of Wells Fargo’s egregious errors is too long to fully commit to this article. But they are extensive..

A taste:

  • Fake Accounts — Starting in September 2016 and continuing to the following March, stories about the bank created fake deposit and credit card accounts in their customers’ names without permission. This led to Sloan’s predecessor’s departure.
  • Failed “Living Will” Test — Wells Fargo failed one of the post-Great Recession regulatory tests in December 2016. This “living will” test determines if the unthinkable were to happen – a bankruptcy at one of these major banks – could they wind down operations without impacting the rest of the market. Wells Fargo failed that.
  • $1 Billion Settlement — In April of last year, the bank agreed to pay $1 billion to settle problems with its auto-loan and mortgage businesses. It was charging customer for insurance without their knowledge and charging for mortgage-rate locks, when it was the bank’s own fault.

These are just a taste of Wells Fargo’s wrongdoings. It has also been slapped with growth caps from the Fed and SEC sanctions.

Now, with new leadership on the House Financial Services Committee, Sloan is finally being called to answer for those problems… even the ones before his time in the top job. Presidential hopeful, Senator Elizabeth Warren – another with a history of TARP involvement – has been loudly and often calling for Sloan to be fired like the former CEO of Wells Fargo.

The point is… this looks bad. And if anything actually comes from all of this, it could be devastating to the bank and others like it. As Chairwoman of the House committee questioning Sloan, Maxine Waters said recently in a press conference: “We are poised to have significant hearings… [with other] bad actor CEOS.”

But with Wells Fargo in the hotseat first, it is the most likely to see something big happen. Of course, betting against the company seems like the best play. But you have to remember, it has plenty of other support on Capital Hill and in the White House. Any kind of penalties might be stymied or completely stopped.

So, there’s no guarantee the bank will face any further problems… at least in the short term. Therefore, shorting its stock or buying put options on it might not be the best move. Instead, there’s another way to play this.

A Trade For Expected Volatility

Rather than playing which outcome Wells Fargo, and hence its stock price, will see, there’s only one sure thing that’ll come out of this: this situation will spur rising volatility.

We’ll see something happen. Whether it’s a steep penalty, further regulatory problems or even Sloan’s ouster… or a complete reprieve from further fines or consequences, it will cause some type of movement in its share price.

This is a rare situation, where you cannot predict which direction something will head… but we know it’ll move in that direction with speed.

This is a perfect scenario for a long straddle trade. A long straddle is a type of options play that bets on movement, not direction.

long straddle

Source: The Options Industry Council

The way it works is by buying both a call option and a put option on a stock with the same strike price and expiration date.

That lets a long straddle trader take advantage in either outcome. Shares fall, the put shoots up in value; shares rise, the call grows.

The only risk is if shares don’t move at all. But with so much intense pressure on Wells Fargo right now, the chance of that is slim.

Let’s look at a specific example…

A Specific Trade on Wells Fargo’s Volatility

A trader looking to use this strategy to play the uncertainty of Wells Fargo’s immediate future could buy an April 18 $50 call for $1.16 per share and then buy an April 18 $50 put for $1.34 per share for a cost of $2.50 per share. Since each represents 100 shares of WFC, that’s a net debit of $250.

That’s the most the trader could lose. But since the nature of this kind of strategy has a virtually unlimited upside, the potential return is also nearly limitless.

If the committee forces some negative consequence on Wells Fargo, or regulatory bodies continue to battle with the bank, shares could plummet. That would make the put option in this trade extremely valuable.

Likewise, if nothing comes of all of this, and the bank continues to carry on… or even loosen the regulatory caps and challenges it’s already faced, shareholders would certainly jump back into this mega bank. That would force the price of the call option in this trade to skyrocket.

In either scenario, this trade wins… in a big way. The return a trader using this specific trade is virtually limitless. And the risk is limited to just the amount of money to enter it.

To reach profitability, take the cost and apply it to the strike price. For instance, if shares rally, this trade would move to black as they pass $52.50. If shares fall, our hypothetical trader enters profit territory below $47.50. Both represent a move of just 5%. We all know a bank in the hotseat with talks about bailouts and liquidity risk face larger moves than that.

We’ll just have to wait and see what happens to Wells Fargo over the next month or so. But we’re positive, something will come to a head… forcing major stock price movement.

— The Option Specialist

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About the Author: The Option Specialist