Options Update: Put Traders Pile on Wachovia Following WaMu Collapse
With the failure of Washington Mutual
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Investors are frantically searching for the next company on the chopping block, and their attention is focused squarely on Wachovia
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In an interview with Bloomberg, Stan Smith, a banking professor at the University of Central Florida, said that “Washington Mutual showed that one of the big ones can go down, and if you are looking at who else in the top 10 is facing the most pressure, Wachovia is right there.”
Driving the fears to a fevered pitch is the fact that Wachovia is the largest originator of mortgages called “option ARMs.” The comparisons to WaMu are easy, as the bank was the second largest originator of option ARMs before its collapse on Thursday night.
Options traders are having a field day with WB today, as more than 108,000 put contracts have changed hands on the stock so far. This wealth of activity has nearly tripled the stock’s average daily put volume and placed Wachovia on our Intraday Volume Explosion List. Nearly one-third of these contracts have crossed the tape at WB’s deep out-of-the-money October 5 strike, catching my eye this afternoon.
As you can see from the chart above, nearly all of today’s volume is trading at the ask price, suggesting that traders are buying these contracts to open new short positions on the company. Furthermore, open interest at the October 5 put totals 29,556 contracts, well short of today’s volume of roughly 34,0000 – reinforcing the idea that we are looking at buy-to-open put activity. As such, we are going to focus on a potential put-buying trade on WB, with the block of 5,000 contracts trading at 10:25 a.m. as our example.
The Anatomy of a WB Put Position
Specifically, in this situation, the trader bought 5,000 WB October 5 puts for $0.85, or a total outlay of $425,000 — ($0.85 * 100)*5,000 = $425,000. For this trade to reach breakeven, WB would need to fall about 53% (in addition to its 28% decline today) to $4.15 per share. We arrive at this target by subtracting the cost of the option ($0.85) from the strike of the purchased 5 put ($5 – $0.85 = $4.15). The total loss for this position is limited to the initial investment of $425,000.
I have to admit that WB’s situation looks pretty dire at the moment, especially with the U.S. government stalling on the proposed $700-billion bailout package for the financial system. However, let’s see if the stock’s sentiment or technical backdrops provide any additional information for today’s hypothetical trade.
Getting Technical
The technical picture for WB is abysmal. The shares are off more than 63% so far this year, with the stock finding staunch resistance at its declining 10-week and 20-week moving averages. WB was in the midst of challenging resistance at the latter of these intermediate-term trendlines when WaMu went belly up. Now, the shares are struggling to maintain psychological support at the 10 level, a region that WB has not closed a week below since February 1991. A close below this region would be a bearish indicator for the equity, and a positive development for the October 5 put position.
The Sentiment Drivers
The sentiment backdrop for WB is extremely bearish, though I would argue that most of this negativity is par for the course given the stock’s poor technical performance. The equity’s Schaeffer’s put/call open interest ratio (SOIR) of 1.60 ranks above 85% of those taken during the past year, and all 15 analysts following WB rate it a “hold” or worse. Additional pessimism from options traders, or downgrades from the 11 analysts issuing “hold” ratings, could work in the favor of an October 5 put.
However, there is the matter of WB’s heavy short-to-float ratio. Currently, 12.5% of the stock’s float is sold short, creating the potential for short-covering support amid the stock’s decline. Traders who have yet to unload their short positions on WB could take advantage of the stock’s 28% plunge today to take some profits off the table. Such a development could work against the hypothetical trade outlined above.
The Verdict?
While a put position on Wachovia looks pretty sound at the moment, I probably would have opted for a nearer-the-money October 11 or 12 strike in light of the potential repercussions from a government bailout. By trading puts at the 5 strike, an investor almost needs WB to be downgraded by a ratings agency such as Fitch or Moody’s, or the company to follow in WaMu’s footsteps. What’s more, this major event would have to happen within the next 3 weeks, given that October options expire on the 17th. However, by utilizing the October 11 or 12 puts, a trader could take advantage of additional weakness in the shares without the need for an earth-shattering development for Wachovia.
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Copyright Schaeffer’s Investment Research. www.schaeffersresearch.com.