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On Wednesday of last week (August 31), a friend of mine sold September 27 calls in Wells Fargo (NYSE:WFC) to hedge shares that he owns. Given expiration was a little over two weeks away, it was really a bet that WFC had hit a wall. The timing made sense because the stock was directly below critical resistance at the 50-day moving average. Moreover, the $27 strike price is near the mid-point of WFC’s trading range over the last two years. So far, not bad, although most hedges of important positions usually involve longer time frames of protection.

Well Fargo sells off sharply after rally right to the 50-day moving average (DMA)
(Click to enlarge)

Well Fargo sells off sharply after rally right to the 50-day moving average

*Chart created using TeleChart

As it turned out, WFC did indeed sell off quickly. The very next day, WFC lost 3.3%. On Friday, WFC lost another 4.1%. The September 27 calls are now already close to worthless. Unfortunately, my friend closed out his short calls right before the selling. Early Thursday morning, someone (or group) traded a 10,000 block of September 28 calls. On the surface, this trading action appeared bullish, and my friend suddenly feared losing out on some major upside. Clearly, he went into the trade unprepared emotionally for the possibility that he might forgo upside potential and even lose the shares if the call options expire in-the-money. He also did not comprehensively review the options action.

I am in the habit of checking the action of all strikes before guessing at the implications of large options volume. In 2009, I conducted a specialized study of options trading to determine what, if anything, I can learn from the volume of options trading (for example, see “What Do Speculators Know from High Options Volume? (Part Three)“). For several months, I followed the options action of many stocks that triggered certain high-volume criteria and concluded that “… options volume alone is a poor differentiator of the underlying stock’s performance, whether we measure maximum gains, minimum gains, or performance to expiration.” Each of my four mini-studies uncovered different twists on this theme. Here is what I found when I looked at options trading in WFC across all months and strikes last Wednesday:

  1. A large block of puts traded on the Jan 20 WFC puts. Implication: it is VERY possible that someone sold the September 28 calls to fund purchases of the puts.
  2. Trading in WFC calls of future months did not show abnormal volume. Implication: if someone really believed WFC could soar above $28 in the next two weeks based on some upcoming news, we should see some similar, albeit lighter, activity in other months by people who want to get more time to see the news play out. Copycats will also choose later expiration when they cannot figure out the exact reason for the excitement. Moreover, savvy traders can try to mask their possession of specific insider knowledge by choosing later expirations and spreading bets across multiple months.

I also looked at the trading in September XLF options for additional clues. Wells Fargo is the second largest holding in XLF at 8.4% of all holdings. If the WFC calls were trading at high volume because of forthcoming good news for the financial industry, then perhaps this bullish optimism would show up in the trading of XLF calls. Instead, I observed massive put volume in XLF relative to the calls.

In other words, the “preponderance” of evidence suggested to me that it was more likely traders were expecting significant downside in the two weeks to expiration (and beyond). In hindsight, I do not think it is a coincidence that WFC sold-off right after the 10,000 Sept 28 calls traded (open interest also increased by about 10,000). On the evening of Thursday, September 2, the Federal Housing Finance Agency (FHFA) announced a lawsuit against 17 financial institutions to recover losses to Fannie Mae and Freddie Mac. This news seemed to represent the bearish catalyst anticipated by traders in XLF – again, likely no coincidence. Ironically enough, the FHFA did NOT target Wells Fargo as a defendant (small relief for my friend!).

Finally, the put/call ratios in financial firms are currently relatively high. For example, Schaeffer’s Investment Research shows that the put/call open interest ratio in WFC is at a one-year high. The recent ramp in the put/call ratio from 0.9 to 1.50 started in mid-July despite the excitement at the time over WFC earnings and directly ahead of the large sell-off that took WFC to two-year lows in August. The put/call ratio is near one-year highs for XLF. Since the bears appear to have financial stocks scoped accurately in their gun-sights, it makes sense, for now, to judge call option activity as guilty until proven innocent … especially when it occurs at the edge of important technical resistance and in parallel with heavy put activity.

Be careful out there!

Disclosure: I am long XLF calls and BAC puts