Any individual stock is given multiples of its earnings potential as an evaluation for its stock price. This is because companies are intended to grow over many years, so a value that is even with its current true value is ridiculous and just about never seen. These evaluations depend on growth.
What just happened to Wells Fargo on Friday
On Friday the Federal Reserve sanctioned Wells Fargo for its bad acting over the last year, with millions of fraudulent accounts and high pressure sales strategies that gave themselves and banks a bad name over the last year. Though wells Fargo can continue accepting new deposits and creating new mortgages, it is not allowed to grow its assets until the Federal reserve is convinced improvements have been made to their practices and board members. So although they can take deposits they can not use those funds for investments, although they can take loans they can not reposes goods and add them to their assets, forcing immediate sales in cases of loan defaults. Also they will need to replace 4 board members which will add a big pause to changing their practices.
It is pretty hard to have sustained growth when growth is sanctioned by regulations, and change is slowed down by board member changes.
As a result of this Wells Fargo estimates a cost of about $400 million to their earnings this year from these sanctions. After 2 straight quarters of big earnings misses as it is. With their average net profit margin being about 25% this should translate to a cost of $100 million to their earnings or $0.02 per share; as opposed to teir estimated growth of earnings for 2018 which would bring it to $4.83. Since they aren't allowed to really grow the $0.02 cent loss should come off of last years EPS, $3.88, making the new expected number about $3.86, 20% lower than what is currently estimated. A real sizable hit. For the next couple months this stock seems somewhat unbuyable. Int he long term, over multiple years Wells Fargo will likely come back form this, but I can't find any reason for the next few months to have any glimmer of hopes.
Pretty likely the stock will go down, how can we make money?
Lets consult the charts
Current price after hours Friday $60.00
Last resistance new support $57.50
Last support $52.50
Year long support $50.00
Nothing is for sure in stocks ever, but I have a big hunch that the stock will drop to at least 57.50 its last resistance line, which it broke in December. Traditional Technical analysis says this resistance line should become the new support. So if you want to play this conservatively, but make a lot of money, target a stock price of $57.50, a drop of $2.50 for the stock 4.1% change. Should be able to get about 1 multiple on your principle with this move in the next month.
Since this is pretty sizable news I think the stock will break down that support pretty easily and drop to the next line, $52.50, a $7.50 change in the stock a 12.5%. With that much of a move you could buy an option with a month or two of time and out of the money and make a pretty sizable profit, 1-3x on you principle.
Now if you really like risk, it might even break down that line and fall to $50.00 , a $10.00 change in the stock or 16.6%. Again this would likely happen in a few months and would result in several multiples on your principle, close to 5x.
The past three options use out of the money options, so if you are wrong on the time or amount of the move you will lose 100% of your principle. If you are not comfortable with this then there are some more options you have.
For a more conservative play a short term credit spread in the calls would result in a little premium, less than 1% of your total stock that you could grab quickly for the coming week or two. Also deep in the money put options will give a leverage of 2-5x on the stock price move (4.1%-16.6%) giving a result of anywhere between 8.2% - 83%. This will limit your risk of being wrong on the timing of the move or size of the move like you have to worry about with out of the money options, but at the cost of potentially multiples of profit. It will add to the costs of the option though as deep in the money options are expensive.
So there are several ways to play this big hit to Wells Fargo and a overview of the risk verse reward of each of them. Me personally I am leaning towards putting a short term credit spread in the calls for some quick cash, and an out of the money option for the next couple months with a target price of $52.50. At that point I would sell most of the position and maybe leave a little on the table if the stock drops further. I would make that decision when the time comes though based on other technical analysis and market conditions.