As we traveled across Canada over the last month on behalf of the M-X, I met many retail investors concerned about the markets and the fate of their portfolios. While some were concerned about the risk associated with individual holdings, many were skeptical as to how much longer the stock market in general could hold up. While the Canadian equity market has underperformed comparative to its U.S. counterparts, history has demonstrated that when the U.S. markets roll over, so does the Canadian market. As the old saying goes “when the tide goes out, all ships sink”
We spend a lot of time focusing on the protective put strategy which is a very effective way of hedging risk in an individual stock. As the share value declines, put options will increase in value and subsequently offset a portion of the loss incurred in that individual stock. However, purchasing puts on each individual security within the portfolio can be very costly.
Since a diversified portfolio will usually follow the market, a more cost effective way to hedge risk would be to use SXO options. SXO options are priced based on the value of the S&P/TSX 60. As the index drops in value, an SXO put option will increase in value.
Important Contract Specifications
European style exercise
Cash settled in Canadian dollars (No shares will exchange hands)
Settlement price is the official opening level of the underlying index on the expiration day
Trading ceases on the trading day prior to the expiration day
Expiration day is the third Friday of the contract month
$10.00 X one S&P/TSX 60 point. Price quoted in index points expressed to two decimals.
0.10 index points = $1.00 per contract
1.00 index points = $10.00 per contract
5.00 index points = $50.00 per contract
25.00 index points = $250.00 per contract
Requires no buying or selling of individual stocks
Cash settled at expiration
Substantial reduction in transaction costs
No interruption of dividend streams
No tax disposition of underlying shares
Effectively hedging a portfolio takes a little effort on the part of the investor. Since most portfolios will not exactly track the index due to unique stock selection and weighting, the portfolio beta must be calculated. The beta of a portfolio indicates the volatility of its return in comparison to an index. In this case, the S&P/TSX 60 index will be used as a benchmark.
A beta of 1 represents the market. Therefore a portfolio that moves more than the market over time will have a beta greater than 1 and a portfolio that moves less than the market will have a value below 1.
Each of the stocks that you hold in your portfolio will have its own beta. I found the information I needed at www.financialpost.com.
If there are share positions of different weightings, the beta of the stock must be multiplied by the weighting in the portfolio. Once this is determined for each of the holdings the average beta may be calculated.
Sample $100,000.00 Portfolio, equal weighted
On May 14th, 2013:
Portfolio value = $100,000.00
Beta = 1.16
S&P/TSX60 at 719
September 2013, 715 strike put = 22.85
Equation: portfolio value X beta
index value X 10
Example: $100,000 X 1.16 = approximately 16 SXO put contracts
719 X 10
$22.80 X 10 = $228.00/contract
$228.00 X 16 contracts = $3648.00
Without the hedge, a 10% drop in the index would result in an 11.6% drop in the portfolio or $11,600.00
If the index dropped 10% from 719 down to 647, the put would have the following value on expiration:
715 strike – 647 index settlement value = 68
68 – $22.85 cost = 45.15
45.15 X 10 X 16 = $7224.00 cash settled in Canadian dollars
The portfolio is worth $88,400.00 considering the 11.6% drop; however the put option profit is $7224.00. The result is that the portfolio is worth $95,624.00
By using the SXO options to hedge the overall risk exposure of the portfolio, the investor has limited a potential 11.6% drop in value to approximately 4% without having to sell any shares.
It should be noted that an investor wishing to offset the cost of the SXO put could sell a call option to create collar strategy provided that the portfolio is not held in a registered account.
For more insight into SXO trading specifications and strategies check out the following webinar links:
Since the European Union (EU) bailout programs began there has been an austerity pre-condition. Mostly the result of German strong arm tactics designed to get member States to restructure social programs so as to level the playing field in a way that supports a single eurozone currency.
The challenge is how does one deal with the extreme conditions in which have not states (Cyprus, Greece, Ireland, Portugal and possibly Spain and God forbid Italy) are trying to manage through the crisis with unsustainable unemployment rates against the political views inherent in the stronger states that further bailouts will simply result in a vicious circle of throwing good money after bad?
Recently that has begun to change!
There is a move afoot among EU politicians that austerity is simply not working. Couple that with clear evidence that the US economy is gaining momentum – albeit ever so slowly – plus more academic literature challenging the austerity approach and politicians are beginning to lean towards a growth oriented strategy.
To that end, the European Commission adopted a reprogramming plan that will help promote growth in Cyprus and strengthen the impact of EU regional funds there. According to the EU press release “the decision to redirect €21 million worth of Regional Funds is intended to help the country deal with the current socio-economic crisis and ensure a quicker delivery of available investments particularly when it comes to supporting small and medium sized business and the employment of young people. This revision was requested by Cyprus earlier this year and has been given added political momentum in the last few weeks The decision will see funds from lesser performing regional policy areas being redirected to where the funds are likely to have more impact for growth and jobs in the shorter term.”
The European Commission also proposed measures to ensure “the better application of EU law on people’s right to work in another Member State and so make it easier for people to exercise their rights in practice. Currently there is a persistent problem with public and private employers’ lack of awareness of EU rules, regardless of whether the national legislation is compliant or not. This lack of awareness or understanding of the rules is a major source of discrimination based on nationality. People also consider that they do not know where to turn to in the host Member State when faced with problems concerning their rights to free movement. The proposal aims to overcome these obstacles and to help prevent discrimination against workers on the basis of nationality by proposing practical solutions.”
According to László Andor, Commissioner for Employment, Social Affairs and Inclusion “The free movement of workers is a key principle of the EU’s Single Market. With much higher levels of unemployment in some Member States it is all the more important to make it easier for those that want to work in another EU country to be able to do so. Labour mobility is a win—win – it benefits both Member States’ economies and the individual workers concerned.”
Of course, structural reforms are one thing. To make this work, there has to be increased efforts by central banks to provide much needed liquidity within the bounds of international agreements.
On that front, I noted reports from Reuters covering the G-7 meetings last week that British finance minister George Osborne “is keen for his peers to focus on what more central banks can do to help growth at a time when most governments are trying to cut bloated debts.”
According to Mr. Osborne, this is “an opportunity to consider what more monetary activism can do to support the recovery, while ensuring medium-term inflation expectations remain anchored.”
The Chicken and egg problem with this approach, as echoed at the G-7 meetings, was the need to focus on bank regulation to re-structure many of the failed banks. The emergency rescue of Cyprus in March acted as a reminder of the need to finish an overhaul of the banking sector, five years after the world financial crisis began.
That too is a political hot potato, as Germany may come under pressure to give more support to a banking union in the euro zone. The plan could help strengthen the single currency area, but according to Reuters, Berlin worries it may pay too much for future bank bailouts if it signs up to a scheme to wind up failing banks. A position that caused grief at last month’s IMF meeting.
While no formal decisions will come out of this meeting, it will lay the foundation for talks at the G-20 leaders’ summit which will take place in Russia in September.
That goes hand in hand with the heated political debate about the need for governments to ease up on austerity, something Germany, Britain and Canada view as a mistake but Washington, Paris and Rome are in favour of.
US Treasury Secretary Jack Lew weighed in during an exclusive interview with CNBC where he opined that “a global recovery cannot be led by the United States alone… There are countries in Europe that have more fiscal space to create a bit more economic demand.”
All of this is a major change in the EU’s approach and must still be adopted by legislatures. And while nothing is guaranteed – note: Germany faces elections this year – it is seen as a step in the right direction, especially in light of Germany’s strong economy reflected in the DAX index which now rests at all time highs, making it the only stock market in the EU that has fully recovered from the crisis.
With this change in focus, there is hope that the EU has finally turned the corner a sentiment echoed at the G-7 meetings in London this past week. In fact, the main focus of the G-7 Finance Ministers seemed to be on Japan and its domestic strategy.
The Bank of Japan (BOJ) has embarked on a liquidity program that dwarfs efforts currently underway by the US Federal Reserve (FED). In an attempt to stimulate the Japanese economy with its heavy dependence on exports and to kick start inflation the BOJ is printing money at a pace that has other Finance Ministers concerned that the Japanese are effectively manipulating their currency. In fact one of the best trades of 2013 has been to short the Yen against world currencies. Noteworthy is the fact that the yen hit a four-year low against the US dollar on Friday, beyond the psychologically important 100-yen mark. It also trades at a three-year low against the euro.
US Treasury Secretary Jack Lew, while recognizing that Japan has growth issues that need to be dealt with, warned that the world has limits on the degree to which it will allow Japan to stimulate its economy, saying that “Japan had to stay within the bounds of international agreements to avoid competitive devaluations.”
Still the general consensus was that a weakened yen was not a hot topic at the G-7 meeting despite ongoing rhetoric about a global currency war. And while that may be true, the G-7 was concerned that Japan’s attempts to engineer an export-led recovery could hinder other regions’ ability to grow.
But writes Reuters, “having urged Tokyo for years to do something to revive its economy, other world powers are not in a strong position to complain now that it is doing so.” Let’s face it, any attempts to rein in Japan at a time when other central banks are doing the same thing seems a bit like crying wolf.
Could it be that financial markets are surging to new highs in recognition that these changes were inevitable? One could argue in light of a changing focus within the EU and the growth oriented strategies being employed by Japan will be a lynchpin of global growth that will allow economies to catch up with the market.
But even with that, one cannot escape the inexorable fact that markets are priced for perfection. And while one should never fight the largesse of central banks we must be mindful that growth can create an inflationary bubble.
Note to Japan… be careful what you wish for!
Thank you to all for attending our Options Education Day in Vancouver. Hopefully all who attended left with a better understanding of how options can be used effectively for all sorts of investment strategies and management, as well as for mananging risk in increasingly unpredictable markets. For those interested in obtaining a copy of Richard Croft’s presentation, you can download it at http://optionmatters.ca/files/2013/02/options-strategy-bands.pdf. Thanks again for coming out, and we’re looking forward to seeing even more participants next year!
Watch the financial news, search the Internet, read the financial press and the most common theme coming from those who are supposedly “in the know” is that the US stock market is ahead of itself. And while those same talking heads are longer term bullish most are waiting for pullbacks to put new money to work. In other words, they are buying on a dip! That likely explains why we have seen only minor corrections that last for milliseconds.
The world is awash in liquidity and interest rates are at or near zero. For most investors equities are the only game in town. So even in a slow growth environment inflation is alive and well in the US equity markets with the S&P 500 composite index at a new all-time high and the Dow Jones Industrial Average crossing 15,000 for the first time in its history.
There has been some justification for bullish enthusiasm as 62% of S&P 500 companies beat analysts’ bottom line expectations during the first quarter earnings parade. The drawback came from the top line where more than 60% of those same blue chip names fell short on revenue. Normally that would be a warning sign as it suggests that EPS numbers have more to do with cost cutting initiatives than with enhanced growth prospects. This time not so much!
Many analysts argue that stocks are a leading indicator which means that stocks at these levels may be providing a glimpse of more robust economic growth one to three quarters out. The bulls also believe that valuations are justified pointing out that stocks are not expensive when measured in terms of forward price to earnings metrics. In 2007 before the crash the S&P 500 was trading close to 20 times earnings. Today it is 15 times forward earnings. Further those lofty PE numbers in 2007 came at a time when interest rates were significantly higher than the current setting.
That said the biggest influence on higher prices may be sentiment. Assuming retail investors are not “in the market” - which is evident in most of the trading stats - it is unlikely that stocks have reached the point of irrational exuberance. The hitch is that institutional investors tend to follow a herd mentality which usually results in stocks doing what is least expected… in this case climbing a wall of worry!
Risk return trade-off
The dilemma is trying to balance potential return with risk. That requires an analysis of what we know that leads to a subjective assessment of outcomes based on applying probabilities to potential scenarios. Suffice it to say the objective is to assess the degree of influence a specific scenario might have on your portfolio.
In summary here’s what we know about US equities; the majority of large cap companies beat on reduced bottom line expectations. We know that management seems focused on returning capital to shareholders in the form of higher dividends or share re-purchase programs. And we know that large cap US companies have the cash in hand or the ability to access debt markets at historically low rates to continue those programs into the foreseeable future. None of these metrics should provide any comfort to investors.
We also know that the majority of large cap names did not beat on the top line despite lowered revenue expectations. And we know from most analyst conference calls that US executives were offering tepid guidance for the next two to three quarters.
To put meat on this skeleton let’s apply some math to the latest quarterly numbers. Assume for example that XYZ has ten million shares outstanding at $100 per share. That implies a $1 billion market cap.
Now XYZ is expected to generate $250 million in revenue which assuming a 20% profit margin flows $50 million to the company’s bottom line or $5 per share. Based on those numbers the company is trading at 20 times earnings ($100 share price divided by $5 per share earnings = 20 times).
Let’s assume that XYZ generates $200 million in revenue which given the 20% profit margin would flow $40 million to the bottom line or $4 EPS. To compensate for slower sales management could use its cash or access the debt markets to reduce the outstanding shares.
Suppose the company bought back 2 million shares at $100 per share. Under that scenario the company increases its leverage through either a reduction in the current cash position or an increase in corporate debt. But with only 8 million shares outstanding the company can report $5 EPS which at its 20 times PE supports the current $100 share price.
Companies understand the importance of maintaining the share price and multiple. It discourages potential takeovers by aggressive competitors and it provides a pool of capital (i.e. its publicly traded shares) to acquire symbiotic businesses that can be immediately accretive to its bottom line.
In order to maintain the share price metrics management must find ways to consistently grow per share earnings and beat analysts’ expectations. The challenge is maintaining the per share metrics in a slow growth environment where management expects a drop off in revenue. Exactly what happened to top line revenue in the first quarter!
The scenario used in the XYZ example is exactly what has been happening in the US equity markets over the past three years. The number of outstanding shares has been contracting at a time when central bank induced liquidity has been expanding rapidly. More money chasing fewer shares results in higher prices. Even if those numbers are not supported by the broader economy!
For those of us who focus on risk management the chasm between the macro economy and the performance of the stock market is a concern. The improving employment picture and the moribund rate at which money is changing hands (i.e. velocity of money) are not at levels one would expect at this stage of a recovery. And certainly do not support strong top line revenue numbers anytime soon.
Of course I could be wrong. Maybe the performance of stocks and the attendant wealth effect will be enough to encourage a pickup in consumption which would show up in the velocity numbers over the next one to three quarters. But that presumes that retail investors are getting the benefit of new highs which is not supported by the evidence.
If the wall of worry remains intact that may well be the most influential driver of the stock market for the remainder of 2013. Institutions have an obligation to deploy capital and since the predominant theme is to buy on the dip there is sufficient cash on the sidelines to prevent a wholesale sell-off in stocks.
The risk is that sentiment changes. Should the US economy or more importantly the European economy stumble bullish sentiment could quickly dry up. In my mind the European Union is the lynchpin because the total GDP of all the EU member states is greater than US GDP. If Europe stumbles it will have an effect on the rest of the world.
Never has there been so much division within the EU between the “have” and “have not” member States. A single currency prevents devaluation which reins in the government’s ability to manage through a crisis. The political divisiveness and extreme positioning that we are witnessing in Spain, Greece and Cyprus may be the tip of the iceberg. If this cannot be contained the EU will implode. At a minimum the EU of the future will look nothing like it did in the past.
What we know is that the global economy remains weak. We think we know that it is getting better but without a clear upswing in the velocity of money further growth will hinge on government spending programs and central bank largesse. Neither of which is a long term sustainable solution.
Investors sometimes expect their managers and / or advisors to buy as long as the market continues to rally. Take advantage when markets are roaring. The trick with that strategy is to exit in time to avoid the carnage that comes from a shift in sentiment.
Unfortunately this is likely the largest disconnect between how money should be managed and how individual investors actually trade. Fact is no one can time the market and long term investors should not be trying to play this game.
Even high powered hedge funds cannot consistently deliver performance based on momentum metrics! They are the most competent players in the momentum game and more than 80% of US hedge funds have underperformed their benchmarks year to date.
When you think about it record high stock prices come with elevated risk levels. Even if we accept the bullish wall of worry scenario, a theoretical valuation floor supported by the US $4 trillion cash-horde on corporate balance sheets and the theory that stocks are historically cheap! The point is you cannot look at a security’s potential without understanding the associated risks.
Your approach should focus on specific long and short term return objectives within pre-defined risk levels. Set out a series of longer term objectives which are sub-divided into calendar year mandates. The goal should be consistency… meeting short term mandates which flow into longer term solutions with minimal variability.
To that end, if a portfolio reaches its short term mandate in the first or second quarter of a calendar year you should consider pulling back on risk – i.e. selling covered calls or buying puts for protection - rather than ramping up exposure to a particular asset class.
Think about it as setting capital aside to well… “buy on a dip!”
Barrick Gold Corp (TSX:ABX) has suffered the same consequences as many of its counterparts in the mining sector. To blame the most recent drop in gold would be misguided. While Barrick suffered a 33% drop in a little under a week on the heels of the gold sell off, the fact is that the downtrend was already well in place.
One concern for the fate of the mining sector sector is the increasing cost to pull the precious metal out of the ground. Some estimates suggest upwards of $1200.00/ounce, up from $400.00/ounce 10 years ago.
There are also numerous articles circulating attributing the stock’s decline to various fundamental issues including mine closures and other disappointments and setbacks. While these reasons are certainly important to consider, when reviewing the chart we can see that the shares are at levels that exceed lows dating back to 2000.
While the worst may not be over yet for Barrick, the current price offers an interesting opportunity to “buy when there’s blood in the streets”. While this presents a rather contrarian approach I believe the market does a really good job at overcompensating.
Most cautious investors would have a hard time putting up the capital to participate in a stock that not only does business in a market with significant uncertainty i.e. the future of gold, let alone one with significant fundamental concerns unique to the company itself.
This is where the option market shines. While the near term future of Barrick is admittedly questionable, an investor interested in locking in the purchase of shares at today’s price without putting up the entire amount of capital needed can consider using a call option with an expiration date greater than 1 year.
By purchasing a long term call option on ABX, the investor can lock in the future purchase of the shares at today’s price regardless of how high the stock is trading over the next year or so. This is accomplished with a greatly reduced commitment of capital.
For example, ABX is trading at $19.15 on the TSX currently (May 1, 2013). An investor wishing to buy 1000 shares would put up $19,150.00 to participate. Not only is the risk unidentified, but the investor has now tied up almost $20,000.00 for an unspecified period of time.
Consider the long term call option alternative. A January 2015, 19 strike call option is asking $4.40. An investor wishing to lock in the purchase price of 1000 shares of Barrick could purchase 10 contracts for a total of a $4400.00 allocation. This represents approximately 23% of the underlying share value.
To take it one step further, in margin account, the investor has the ability to sell short term call options against the longer dated call options. This is a form of Calendar Spread. To learn more about Calendar Spreads and variations of the strategy watch this video http://www.m-x.ca/video_details_en.php?id=143.
In this example, our strategy consists of buying a call option expiring January 2015 and selling near term, out-of the- money calls. This approach will help lower the cost basis of the longer term option month over month which will in turn lower the break even point of the position on expiration.
We would calculate the break even point on the trade by adding the $4.40 premium to the $19.00 strike. As a result, ABX shares would have to be trading above $23.40 if held to expiration.
Investors should note that a loss would be realized if the shares are trading below the breakeven point on expiration. Furthermore, The option will expire worthless if the shares are trading below the strike price.
As mentioned, we could significantly reduce this break even point by selling calls month over month. For example, The June 2013, 23 strike call is selling for $0.25. This is approximately 5.5% of the premium. With approximately 21 months until the January 2015 expiration, the investor can consistently collect a premium by writing calls against the option expiring in January 2015.
Of course no strategy is perfect. Investors should note that if the shares stage a significant rally beyond the written strike the option may have to be rolled to avoid assignment. If not managed properly, the investor may be forced to close the position resulting in a potential loss.
To take it one step further, at any point within the time frame of the trade, the investor can use some of the premium collected from call writing to purchase a short term Protective Put. This will offset a portion of risk during periods where there is an expectation of weakness.
Benefits of implementing this strategy include:
- Lower cost
- Identifiable risk exposure
- Reduced breakeven point
- Leveraged returns
- Less volatility then the stock position as the option will move at the rate of its delta
Options trading strategies such as buying a longer term call option and considering selling short term calls against it is a great alternative for investors who wish to participate in an opportunity at a reduced cost over a longer time horizon. The investor can benefit from a lower breakeven point and a monthly reduction in the risk exposure. To offset short term uncertainty, the call premium collected can be used to pay for a portion of the cost of protective put. This results in a short term hedge against a possible drop in ABX share value at a reduced cost.
The last 2 months have been nothing short of a roller-coaster ride for Canadian investors. For most of 2013, the resource stocks have been struggling while the bank stocks were a glimpse of hope. That was short lived as February rolled in as a new round of selling started pressuring the darling Canadian banks. We have now seen close to a 10% drop in some of the bank stocks as investors start to pile in on the sell side. A recent article in the Financial Post has suggested that the short interest in the Canadian Banks is at its highest level since the Lehman collapse.
Clearly, the fears associated with the Canadian housing correction have traders betting that the Canadian banks will hit a bump in the road. This is a double-edged sword because when a short trade gets crowded, it can lead to sudden short squeeze moves higher. Equally, if the stock started to break down, the heavy short interest could fuel investor concerns and drive emotional selling. It is clear that a convincing argument can be made for both bull and bear scenarios which leaves investors more confused than ever.
The best part about trading options, investors can build a strategy to profit from volatility rather than direction. For this blog article, we are going to focus on using a Strangle on the shares of CIBC. If you would like to learn more about the Strangle, watch this short video:
Considerations for CIBC (TSX:CM):
April 29th Price: $79.19
2013 High: $84.00
2013 Low: $76.81
Next Earnings: May 23rd, 2013
Next Dividend: June 26th, 2013 ($0.94)
Our trade thesis: With a substantial short interest in the stock, it is likely that the May 23rd earnings announcement could be a catalyst to trigger a substantial market move. With us moving into the seasonal “Sell in May and Go Away” period, CIBC is capable of making a material move either higher or lower.
We will open a strangle strategy using two “out-of-the-money” strikes out to June to ensure enough time to get a potential price impact from the earnings.
Stock Price: $79.19
June $80.00 call is $1.15
June $78.00 put is $1.05
The break even on the spreads on expiration is $82.20 on the upside and $75.80 on the downside.
What can be considered here is that volatility is very likely to remain high as we move toward the earnings, which means a trader has the next 3 weeks to “feel out” the direction of the stock while the options retain a good earnings volatility premium. If over the next 3 weeks the trend of the stock becomes more evident, the trader can recover some of the premium from the losing side of the trade to bring the break-even point lower.
The further consideration is that if a new bullish advance was to get underway for CIBC that sees the stock exceed its 52 week highs, traders could exercise the $80.00 call and take ownership of the stock. Subsequently they can hold the underlying stock for further upside and put themselves into a position to receive the $0.94 dividend at the end of June.
This strategy, while expensive from a premium perspective, gives traders a neutral perspective during a time when there is an ever increasing likelihood for future volatility and the ability to enter the stock if a new uptrend was to get underway.
Last Tuesday at approximately 1:00 pm EST, a Tweet from the Associated Press (AP) Twitter account read as follows; “Breaking: Two Explosions in the White House and Barack Obama is injured.”
Within a space of three minutes, US $136.5 billion of the S&P 500 index’s value was wiped out. The S&P 500 index fell more than 14 points. Sources from AP and the White House quickly dismissed the report as false, and within a minute of that, markets recovered all of the lost ground.
The short term shock and awe raised more than a few eyebrows; it brought back memories of the flash crash, provided further evidence about the skittish temperament of the financial markets, emphasized the downside of trading on unsubstantiated rumors and highlighted the importance that social media plays in the instantaneous dissemination of news.
What did not receive as much attention was the rapid erosion of specialist bids on hearing the rumour! At the heart of an exchange are market makers and floor specialists who match buy and sell orders presumably maintain tight spreads between the bids and ask prices and generally provide liquidity for various financial instruments.
The rapid sell-off on Tuesday had more to do with the evaporation of specialist bids rather than a significant spike in large sell orders hitting the market all at once. In short the specialists and market makers pulled their bids after the first tweet and reinstated them at much lower prices.
Investors with hair triggers entered market orders that were executed at prices that were in some cases were well below the previous trade. Mind you most of these hair triggers were pulled by high frequency traders whose orders were originated by computers using algorithms that track among other things flash news from social media sites.
That bids evaporated may be the most important lesson to gleam from this event as it lays the foundation for what is to come. I say that because the specialists’ action this was a rational response to a set of known circumstances.
Professional market makers and specialists are well aware that high frequency trading is the single largest contributor to daily trading activity in the US markets. While these same floor traders may not have the specifics that drive high frequency trading decisions, they certainly have a peripheral understanding of the algorithms. At least they know enough to get off the tracks when a high frequency freight train is bearing down.
That is one of the basic tenets of efficient market theory. At the core of efficient markets is the assumption that there is no free lunch. If a trading system becomes too successful – which most believe is the case with high frequency trading – other market participants will take steps to mimic the strategy and over time will eventually price out any excess return. I suspect in the fullness of time, it will become virtually impossible to earn excess returns with any short term trading strategy.
That does not mean that one cannot create wealth in the financial markets. Far from it! In an efficient market mean reversion plays a role… which is to say markets and individual securities will experience short term ebbs and flows that go beyond rational expectations but over time those same markets and securities will gravitate to a value that is predicated on reasonable fundamentals.
The degree to which a security ebbs and flows – i.e. the security’s inherent volatility - is determined by short term sentiment which, by the way, is priced in the options market. A classic case study of this theory being put into practice can be seen in the price action of Blackberry.
From an intraday high well above $45 per share, the stock have fallen 66% to close on Friday at $15.25. At $45, most would now agree that Blackberry had gotten ahead of itself being priced as a company where there was little competition. That’s not rational as there comes a time when technology companies must deliver new products in order to remain competitive. Without that investors begin to re-value shares using other metrics. That can be a very painful shift that Blackberry investors have witnessed firsthand over the past six months.
With growth slowing, most analysts and longer term investors see Blackberry as a value play. The question is what value do you place on the company which is another way of saying what value should the company rest at when mean reversion takes root? The answer to that hinges on your time horizon.
This is where options can play a role by helping us determine a range of reasonable outcomes given longer term metrics that take into account mean reversion. For example, the Blackberry January 2014 15 calls (these are the at-the-money options) are valued at $3.00 (based on Friday’s bid ask spread). The Blackberry January 2014 15 puts were valued at $2.85 as of the close of trading on Friday.
If one were to buy both the January 2014 15 call and 15 put the total cost would be $5.85. At this point you would not care whether the stock rallied or sold off. If it rallied the calls would profit if is sold off the puts would benefit. This behavior is what determines an implied trading range.
We get to an implied trading range by simply adding and subtracting the total cost for the call and the put from the 15 strike price. In this example, Blackberry has an implied trading range of $9.15 $15 strike price less $5.85 cost for the Blackberry straddle) to the downside and $20.85 ($115 strike plus $5.85) to the upside.
If you are bullish on the outlook for the company, you would opt to hold out for the upside potential which in this case implies a target above $20 per share sometime between now and January 2014. If you were bearish, than the longer term downside target is around $10 per share. The trick with mean reversion is to stay invested long enough to see the fruits of one’s labor.
Over the past 30 years, globalization has made the world a much smaller place. Supported by advances in technology and communications, corporations have sought markets outside their domestic borders. As a middle class takes root in emerging economies, those markets become increasingly important to the bottom line of global companies. The result is greater profitability and enhanced balanced sheets.
Globalization and the attendant removal of trade barriers has, for the most part, been a positive experience. It spawned a new class of consumers, sparked unprecedented global growth and created efficiencies that allowed for rapid expansion without inflation.
But all that may be changing. Since the financial crisis of 2008, there has been a marked decline in the value of international settlements, which has caused some companies to shift their emphasis away from international commerce onto localized markets, in which revenue is more dependent on domestic consumption.
David Francis, writing in the Fiscal Times (www.fiscaltimes.com) cites a recent McKinsey Global Institute report that measures how much money was removed from the global financial system in the wake of the financial crisis and the worldwide economic slowdown. In 2007, US $11.8 trillion in capital in the form of investments and loans moved internationally, representing 335% of global economic production. By 2012 that number had declined to US $5 trillion, representing 312% of global output. For perspective, that brings the level back to where it was in 2000.
That data is disconcerting, but it is not clear what’s behind the numbers. It may be the result of global government stimulus programs supported by liquidity infusions from the worlds’ central banks. There is no doubt that central banks are adding liquidity, and there is little evidence to suggest that consumers are spending. That is clear from the divergence in global money supply which is at record highs versus the velocity of money at record lows. The velocity of money is a gauge of how quickly money changes hands, providing a macro snapshot as to the spending patterns of consumers.
In keeping with those themes, we find ourselves working with a playbook where old rules no longer apply.It appears that global growth – anemic as it is – is being propped up by government stimulus that focuses on domestic economies. Out of necessity, that may be an appropriate strategy, but it is artificial and longer term, and will negatively impact global growth and probably delay any potential recovery.
The desire to artificially stimulate global economies also sets off a series of unintended consequences that wreak havoc on the normal interaction between investment assets. To make that point, follow the bouncing ball; central banks add liquidity through the purchase of government debt. Governments take that capital and use it to stimulate economic activity through various initiatives. Excess liquidity leads to domestic inflation. To remain competitive the country’s currency is devalued. But within the Eurozone devaluation is not an option, which leads to bailouts and ultimately economic chaos.
When all the major central banks are adding liquidity at the same time it should debase all currencies. For countries that cannot arbitrarily devalue, there is economic fallout; Cyprus being the tip of that iceberg.
All of this should lead to a spike in the value of hard assets like gold and silver which theoretically act as a currency substitute. And it worked for a while as gold reached record levels. But lately hard assets like gold, silver, oil and copper have become casualties of unexpected consequences.
We know that the Cyprus economy was artificial – based on ultra-low tax rates – and rested on a foundation of quicksand. Despite that, if it were standing alone its economy may have survived. But as a member of the Eurozone it had to seek assistance from other members, which resulted in currency controls that forced the government to sell hard assets – i.e. its gold reserves - to pay for social programs. That strategy was never factored into the pricing metrics of gold when analysts promoted its role as a store of value and “crisis insurance.”
Still, this should not come as a surprise to investors. We have long questioned the value of gold as crisis insurance believing that the ultimate store of value is the US dollar. In a crisis, people will flock to the US dollar as the last haven of security. In fact we have seen that recently as the US dollar has risen ever so slightly against all major currencies
The good news is that a strong US dollar lowers the price of commodities. Most of that fallout felt in base metals, oil and agricultural products that negatively impact countries like Canada but is a positive for US and Eurozone consumers.
Lower commodity prices, combined with ultra-low interest rates, may be enough to kick start US consumers. That could spark some much needed growth in the third and fourth quarter, which will appear on the bottom line of consumer discretionary and industrial companies.
Gold closed on Friday at US $1,407 an ounce, down 5.9% on the week. Even before last week, gold was vulnerable as it had not been able to break through its 50 day moving average. Cyprus was simply the lynchpin that caused gold to sell-off to levels that are now well below its 50 day and 200 day moving average. And most analysts do not expect it to recover anytime soon. That’s because gold typically follows its primary trend – which is clearly bearish - for long periods… sometimes years.Assuming of course that there are some old rules that still apply!
The real concern for gold and the Eurozone is that Cyrus is not the only Member State with serious problems. We suspect that further bailouts will follow the same model that was applied to Cyprus; i.e. any country requesting a bailout will have to agree to major structural reforms. That will be difficult in the current political climate which means that the Eurozone will continue to be a black cloud hanging over the financial markets.
In light of so much uncertainty, we continue to believe that our best defense is to invest in solid dividend paying blue chip stocks that have and continue to generate the bulk of their revenue domestically. It is simply the best alternative in a bad environment. But even with that thesis we recognize that investors will likely seek shelter over the next few months, which is why the “invest ‘til May then go away ‘til labor day” remains our mantra.
To that end, I remain convinced that investors should maintain an overweight position in cash and high quality preferred shares. The former for security, the latter for yield! Further, any exposure to dividend paying stocks will provide cash flow that will help stabilize portfolios during a black period.
The straddle hedgethat I discussed in the March 4th, 2013 blog will also provide some insurance because I am under no illusion that Cyprus is the end game. Unfortunately the equity markets are susceptible to Eurozone shocks and it is impossible to predict which country will come onto center stage with its own set of problems. At least with the straddle hedge, you have some downside protection and with the over-weighted cash position, the wherewithal to take advantage of opportunities.
Listen to the US media and you might think your portfolio has underperformed, with US stocks making record highs with a 12.14% year to date return for the iShares S&P 500 index ETF (TMX: XSP). Note this ETF is hedged to the Canadian dollar, which added about 3 percentage points to the year-to-date return.
Unfortunately, Canadian stocks have done nothing that remotely resembles the US numbers. The S&P TSX 60 Index Fund (TSX: XIU) is virtually unchanged, down -0.19% year-to-date, including re-invested dividends. No wonder Canadians feel left out!
It gets worse if you were to annualize the first quarter performance data for US equities. It leads to a very lofty number! On the other hand, if the performance is based on an overly optimistic forecast, the best may be behind us, in which case not so much!
That’s where perspective plays such a critical role. Ask what’s propelling US equities; economic growth, Fed liquidity or Wall Street spin? Seek supporting evidence by perhaps looking at the Canadian market, which I believe is a more accurate gauge of current conditions.
At least the Canadian equity markets are being spearheaded by economic activity rather than liquidity enhancement. Although some would argue that Canadian indices have been hobbled by major declines in the price of gold and oil, and therefore are not reflecting the economic growth prospects that seem to be driving US equities.
To that point, I would argue that recent weakness in Canadian banks has been a major stumbling block for Canadian equity indices. It is hard to argue that banks are not representative of broader economic activity.
If you accept that Canadian stocks are resting on a stronger foundation, you might want to focus on high dividend paying stocks of blue chip Canadian companies, which tend to move more deliberately. The iShares Dow Jones Canada Select Dividend Index Fund (TMX: XDV), which represents a basket of such companies, is up 3.57% year to date.
You might also consider covered call writing strategies that generates cash flow, although the risk reduction metrics that accompany the strategy tend to reduce short term fluctuations, both up and down. At least the strategy provides some defensive characteristics in your portfolio.
If the economy is really as strong as some investors believe these two strategies will do well. If the economy is not as strong as anticipated these strategies will offer some downside protection with a floor supported by solid dividends.
The point to all of this is that perspective should not be guided by sentiment but rather supported by facts.
On February 28th, 2013 we wrote a blog discussing if Royal Bank was worth investing in. To read the blog, click here: http://optionmatters.ca/blog/2013/03/01/royal-opportunity/
Our focus was to find an interesting way for investors to play Royal Bank.
At that time in February, these were the facts:
- Royal Bank was trading at $64.12 (02/28/13)
- Royal Bank is paying a $0.60 dividend on April 23rd
- The stock was trading $10.00 lower just 3 months earlier (certainly not a buy low opportunity).
However, at the same time if an investor did not buy that day, the markets could have continued to advance over the next few months, leaving timid investors on the sidelines.
For the stock investor, it has to be a black and white decision to buy. An investor utilizing options can apply a simple strategy as an alternative to buying the stock outright. In that February blog, we looked at the idea of using a traditional call option as a method of entering the Royal Bank Position.
Back then we wanted to control 1,000 Royal Bank shares, but wanted to use the call option as our entry strategy. In that example we bought the April $64.00 call for $1.25. The option expires April 19th, which is 4 days prior to its next x-dividend date.
What was our game plan?
If Royal Bank stock continued higher and was trading anywhere above $64.00 come options expiration, we would exercise our right to buy the shares at $64.00 and own the shares prior to the April 23rd dividend.
By having the call options locking in the upside potential, we had 6 weeks to try to accumulate the stock at much more attractive prices. If at any point over the 6 weeks the market gave us the opportunity to buy Royal Bank shares at a discount to its current price, we would take advantage of it.
What did we accomplish? We created a strategy that gave us a second chance at a first entry. Think about it. If we were wrong for wanting to own Royal back in February, the call will expire but we would have had the chance to buy the shares at much better prices. In the same regards, if Royal continues higher, we had fixed a $64.00 entry and would have exercised prior to its April dividend.
Now let’s look back at what has happened over the last 5 weeks up until today’s trading (9 days prior to expiration).
Over the last 5 weeks, the stock has traded:
- As high as $64.48 (02/28/13)
- As low as $58.82 (04/08/13)
This worked out perfectly for this example. An investor that bought the shares back in February at $64.12 would be down on the shares hoping that the stock comes back. On the other hand, any investor that paid $1.25 for the call option is likely to lose the total premium, but had several weeks of opportunity to buy the stock as much as $5.32 cheaper. The key observation for the dividend investor is that we did not give up a single dividend payment to execute this strategy. What is it that investors should take away from this exercise? That options are not just for speculation, but can be effectively used as an investment tool in attempts to optimize potential outcomes.