Wells Fargo May Face Short Term Pressure
Vy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Wells Fargo (NYSE: WFC) is currently trading at a level near $34 again. It had been at this level twice before in 2010 and in 2011 but had never broke the resistance at $34.
At this level, it will be a good idea to sell calls with a strike of $34. Here is why.
When the bank received funding from the government under the Troubled Asset Relief Plan (TARP), the government received warrants. These are call options to buy Wells Fargo shares at a price of $34.01. These warrants are long dated options, and the time before this option expires is a long time, until 28 October 2018, more than 6 years away. Indeed, I believe that these TARP warrants are very attractive securities in the long term but this will be the subject of another post.
Wells Fargo had repurchased a significant number of these TARP warrants from the treasury. However, there are still a significant number of these warrants left outstanding in the hands of savvy investors and hedge funds. As these investors bought the out of the money warrants at a relatively high price (due to the long time value), I am sure they would likely be selling calls against their holdings of these long dated TARP warrants, trying to make some money while waiting for 2018.
This is not a very risky trade for them. Holding TARP warrants at a strike of $34.01, if one sells a $34 call against the warrant, one essentially is doing a spread and the risk is minimal. Even if the price of the shares goes above $34, their loss on their short calls would be somewhat offset by their gains on their TARP warrant.
It would be even more profitable if the underlying calls that they sell expire worthless so they get the premium of these call warrants and still get to keep their TARP warrants.
Hence, I believe that while the price of Wells Fargo is near $34 (or even slightly above $34), hedge funds will be selling calls at this level. When they have had their fill of short calls, they would start to short the shares proper to bring it down so the calls that they have shorted will expire worthless.
I believe that is why you see a large open interest in the calls with a strike price of $34 expiring in May 2012. Hence, come end of May, Wells Fargo will likely be trading less than $34.