How to Play the Wells Fargo earnings announcement for tomorrow

Wells Fargo & Company (WFC) will announce earnings tomorrow.  What is interesting to me is that Implied Volatility of the Weeklys that expire tomorrow is 52 while the IV of the February options is only 21.

As is often the case going into earnings, there is a huge IV advantage to buying calendar spreads, buying the “cheaper” February options and selling the “costlier” Weeklys with only one day of remaining life.

The important thing, as always when trading calendar spreads, is to pick the right strike price.  I like to make the assumption that I really don’t know which way the stock will move after the announcement but to buy calendar spreads at at least two strike prices so I have a range within which I will make money (maximum gains come when the stock closes on Friday at exactly a strike price of the calendar spreads you have bought).

The whisper number for WFC is $0.92, three cents ahead of the analysts’ estimate. WFC has a 42% positive surprise history (having topped the whisper in 14 of the 33 earnings reports for which we have data).

The average price movement (starting at next market open) within ten trading days of all earnings reports is +2.1%.  That is the important number for me.  That represents a move of about $.74 for a stock trading right at $35 today.

Today I bought in my personal account 30 Feb-13 – Jan2-13 35 call calendar spreads for $.34, shelling out $1020 plus $75 in commissions at thinkorswim.  I also bought 30 Feb-13 – Jan2-13 diagonal call spreads (buying 36 calls and selling 35.5) for a debit of $.16. (There is a small maintenance requirement here for one day.)  These cost me $480 plus $75 in commissions.  My total money at risk is $1500 plus $150 in commissions, or $1650.

At the end of the day tomorrow, I will buy back any in-the-money short calls I have and will probably unload the February calls as well.  The risk profile graph shows that I will make a gain if the stock moves less than $1 in either direction:





If the stock moves less than a dollar either way I should make a profit.  If I am lucky enough for it to close between $35 and about $35.70, I could double my money.  It is sort of fun to have a little investment like this that could double in a single day.  Worst case scenario, I will have 60 calls which have a five weeks of remaining life.  It seems to me that it is unlikely that they will be worth less than an average of $.28 which would be a break-even number for me.

We all know that market makers have an incentive to push the stock price (through using their essentially unlimited market power) to manipulate the stock price to exactly a strike price on expiration Friday (after all, they are usually the sellers when the public buys puts and calls).  If the stock ends up exactly at a strike  price, all those puts and calls they have sold will expire worthless.
If they pick $35 as their price target, I will celebrate with a big night on the town this weekend. 

Happy Trading!

Terry