Wells Fargo (WFC) Breaks Out Before Earnings

After trading in a relatively wide range for the past quarter, the share price of Wells Fargo & Company (WFC) has recently broken out to the upside ahead of the company's fiscal fourth quarter earnings announcement. Wells Fargo has recently pushed higher though a zone that is relatively thin on buying volume. Analysts are forecasting the bank to report $0.99 in earnings per share (EPS) to go along with $18.62 billion in revenue. This represents a nearly 60% expected increase in profit compared to the same quarter a year ago.

The financial sector has been on the rise of late, as investors appear to be seeking stocks based on value rather than speculative growth. Wells Fargo stock has nearly doubled the recent pace of the red-hot financial sector, rising 15.4% over the past month. This could be because bank shares overall were considered undervalued, while Wells Fargo in particular has a more attractive entry price on a per-share basis.

Option traders appear to be taking positions demonstrating that they believe the recent share price increase will continue in the near term. That's because recent trading volumes heavily favor call options over puts, and the open interest seems to illustrate that traders are buying calls while selling puts. The stock has also recently broken through a zone typically marked by heavy trading volume to establish a new 52-week high.

Over the past month, Wells Fargo has outperformed each of the top 10 holdings of State Street's Financial Sector ETF (XLF), with the exception of The Charles Schwab Corporation (SCHW). This has been while the sector has overperformed the market as a whole, as investors continue to seek stocks positioned to benefit from high inflation and rising interest rates in the future.

Recent Sector Performance

Wells Fargo is one of the top ten holdings of State Street’s Financial Sector ETF (XLF). The sector has recently been one of the few sectors to outperform the market at large. Over the past month, XLF has added 7.1%, while State Street's S&P 500 Index ETF (SPY) rose 0.6%. The chart below depicts the recent performance of WFC and XLF compared to nine of the top sectors of the SPY.

It's notable on this chart that sector rotation appears to show that investors are positioning themselves to be prepared for more hawkish policy from the Federal Reserve, including the increase of interest rates to combat inflation. The top performing sectors—energy (XLE), XLF, consumer staples (XLP), and healthcare (XLV)—are considered relatively "safer" bets during times of increased regulatory pressure. That's because these sectors reflect needs and necessities, rather than wants or speculative growth.

The worst performing stocks—technology (XLK) and consumer discretionary (XLY)—typically underperform during times of high inflation. Rising interest rates can put a drag on technology stocks because of their large amounts of debt, while consumer discretionary falls due to the assumption that consumer buying power will diminish, as the focus shifts to "needs" over "wants." This sector rotation could be traders and investors anticipating the next stage of the economic cycle.

Breaking Down the Financial Sector

The financial sector itself is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. This sector comprises a broad range of industries including banks, investment companies, insurance companies, and real estate firms. 

The financial sector is considered a good investment in an economy with rising interest rates because companies in this sector tend to increase the rates they charge for loans they extend to others. In addition, many of these companies have borrowed capital at a lower rate based on prior years' market conditions. That creates a natural tailwind for any of the core financial activities at these companies.

The chart below compares the recent performance of Wells Fargo with the top holdings of State Street’s Financial Sector ETF (XLF).

This chart helps illustrate how, over the past month, and specifically since the start of 2022, individual stocks in the sector have been moving upwards. In fact, of the top ten holdings of XLF, the only stock to post a loss over this period is BlackRock, Inc. (BLK). 

Wells Fargo has recently overtaken Berkshire Hathaway Inc. (BRK.B) as the second-best performing stock of the sector, behind only Schwab. This could be because investors are greatly anticipating Wells Fargo earnings.

Volume Profile

Comparing price action and option trading can provide chart watchers insight into the sentiment traders and investors hold toward a company's future performance. However, further context of price action in terms of volume could illustrate areas of support and resistance, which could provide additional context to option open interest. The chart below illustrates the recent price action of Wells Fargo, in addition to a price-based volume pattern on the left side.

The recent trading range of the Wells Fargo share price is highlighted in blue. The range is fairly wide, topping out at the $52 level, with a lower bound around $47. This trading range coincides with the heaviest areas of volume, illustrated by the volume profile on the left side of this chart.

This price-based volume pattern depicts the prices where investors have bought and sold the shares previously. A noticeable amount of buying in the past often implies that investors will feel the desire to defend their positions at those same prices by buying more shares or at least not selling any further. When volumes at a given price are low or nonexistent, it implies that few, if any, investors have the need to defend their positions at these levels.

Notable thin volume zones appear above the trading range that Wells Fargo recently broke out from to the upside. The area in which volume appears the heaviest, which is the top third of the most recent trading range, is known as the point of control. This identifies the price level where most trades took place. For Wells Fargo, the point of control appears on the chart around the $50.50 price level.

The Wells Fargo share price recently closed above a thin zone of bearish volume, highlighted by the red rectangle. From underneath this zone, it would have acted as resistance. It is currently significant that the Wells Fargo broke above this level. If the Wells Fargo share price were to retrace and fall back below this zone, there is a thin volume zone of bullish volume, highlighted by the green rectangle. This is a price level that could represent support if the Wells Fargo share price were to fall.

These support and resistance levels show a large range of support and resistance for prices. As a result of this, it is possible that any news, surprisingly bad or good, will catch investors by surprise and could generate an unusually large move. After the previous earnings announcement, Wells Fargo shares rose by under 1% in the day following and started to drop the following week. Investors may be expecting the same kind of small move in price after this announcement. With lots of room in the volatility range, share prices could rise or fall more than expected.

Options Look

While the Wells Fargo has recently broken out from a relatively wide trading range, it appears that option traders are positioning themselves for the share price to continue to rise in the future. That's because recent trading volumes on Tuesday favored calls over puts at a nearly 2-to-1 ration. The open interest for Wells Fargo features 1.2 million calls compared to 1.1 million puts. While these numbers are very close, a further analysis of open interest and trading volumes is compelling.

Over the past five trading days, 72% of the options traded have been call options. In addition, 86% of the notional value, or total dollar amount, of all option contracts have been call options. This represents a growing bullish outlook toward Wells Fargo.

For Jan. 21, the next monthly expiration date for options, it appears option traders are placing significant bullish bets on Wells Fargo. That's because for options at the money and one strike either direction calls outnumber puts nearly 8-to-1. Nearly all of the open interest for these strikes comes from the $55 call, with 35,000. This strike nearly coincides exactly with the bottom of the bearish thin zone near the top of the chart. This is significant, because if Wells Fargo delivers a poor earnings surprise and this large number of bets were to unwind, it could provide significant downside pressure on the stock.

There are a significantly higher number of out of the money put options than calls. At first glance, this would appear incredibly bearish; however, implied volatility for these options is falling, suggesting that more traders are selling contracts on short positions in these options. This could be option traders selling positions to collect elevated premiums ahead of earnings while implied volatility is high. The fact that traders are more willing to sell puts out of the money than calls could mean that there is less of a fear of a significant move to the downside after earnings.

Wrapping Up

As one of the bellwether bank stocks, investors will be watching Wells Fargo earnings closely. The company has led a surging sector, and investors will be keen to see continued follow through or a potential reversal to the downside. Option traders appear to be taking advantage of elevated premiums due to the pre-earnings share price increase by selling puts, while continuing to buy calls.