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Wells Fargo Dividend Play

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Jill: Hey, dividend traders/investors...this one is for you! Don't just look at our thesis as a quick trade to add to your P&L. Really take the time to understand the strategy because everyone cares about dividend plays and how to add income to your portfolio. Options and the underlying are impacted differently than just straight long or short equity plays. I would also recommend paper trading this before committing capital to our newer traders because this is one of the most valuable tools for your trading tool chest. Don't rush it, learn and understand options and dividend trades.

Before we get to the strategy, let's review the bullishly-biased thesis that Skip and I have on Wells Fargo (WFC). It is the fourth-largest US bank, has a more stable business model than its peer group since it does not involve most of the trading activities done at other banks. Commercial lending is the biggest sector of the bank, which has been on the rise for the past year.

The company announced that the Federal Reserve Board had approved their 2013 Capital Plan on March 14, which includes a proposed dividend increase to $0.30 per share. With Bank of America (BAC) and Citigroup (C) paying next to nothing in dividends, WFC is now the biggest dividend payer among large banks in the US. At 30 cents per quarter, shares in WFC will yield us a healthy 3.24%, well above the industry average of 1.9% and slightly above the number 2, JPMorgan Chase (JPM). Goldman Sachs (GS) will pay a dividend of only 1.4% at current prices.

WFC is trading at a very attractive valuation, while expectations for earnings are really good. It's already the biggest dividend payer among mega-cap banks, and still has a low payout ratio. Let's turn it over to Skip and see how we can use options to capture the dividend play.

Skip: In low interest rate markets the synthetic call becomes a better way to buy a call than the buying of the actual call because: 1) long stock might be able to capture a dividend(s); 2) long stock can be sold during premarket opening and after-market close timeframes and 3) the actual call can become a short sale used to lock in any, that call being sold short thus morphing the position to one of a conversion (long stock, long put, short call -- the put and call being of the same expiry and same strike price).

During high interest rate market environments the cost to carry long stock via the synthetic call approach greatly hampers this tactic, because higher rates of interest subtract from the potential net gain of any synthetic call.

In order to be able to use the synthetic call approach the trader must have discretionary capital available to prudently use such a tactic. In addition, the capital used to buy the synthetic call must remain in the position until the time has come to close the trade. That time factor is predicated by the time remaining to the expiry of the put bought that created the synthetic call at its inception.

WFC sets up now as a controlled, low-risk speculative synthetic call buy. WFC analysts have an average earnings estimate for WFC's first quarter performance of 88c/share. If so that would equal a 17% gain over the first quarter of 2012's earnings. The site Earnings is using a 90c/share number (see: The release date for these WFC earnings is April 12. Thus, the potential for an upside surprise is in play. Also in play is the excellent potential for WFC to raise the quarterly dividend to $0.30 pershare. If so the dividend yield basis a $37 share price, and using $1.20 as the annual dividend would equal 3.2%. Technically WFC has declined from the top it made at $38.20 on March 15th. However WFC is only a few points away from making an all-time high ($40 per share).

The trade we like now is a synthetic call (also known as the long stock, married put position) using the 37 strike put that expires in May. The total risk for the synthetic call is $1.00 minus the dividend received, if the stock is owned on the ex-dividend date which as of now is expected to be in late April although WFC has not announced such as of now.

Trades: Buy 300 WFC shares for $36.95 and buy 3 WFC May 37 puts for $1.05.

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