Is there any Fuel left in the Energy Sector Bull Advance?

Canadian energy stocks have been bulling higher for most of the year.  The iShares S&P/TSX Capped Energy ETF is up 18.68% year-to-date (as of Aug 28). This renewed strength in the energy stocks has been a major contributor to the robust bull market advance in the broader Canadian indices.

Can the energy stocks keep rising?

While there are a number of fundamental input variables and broader market conditions that must be taken into consideration, there is one underlying divergence that continues to raise red flags.  This is the divergence between the underlying stock prices and the price of crude oil and natural gas.

The Divergence

January 2014 low of WTI crude oil was $86.00.  Between January to June, crude oil prices have risen to a high near $105.00 (on the October contract) or a $19.00 rise.  During that advance, the iShares S&P/TSX Capped Energy ETF has rallied from $17.00 per share to a high near $21.50.  Since the June highs in crude, we have seen a steep decline of over $12.00 a barrel, bringing prices just a few dollars from the start of the year.  At the same time many energy stocks have not reacted.  As an example, Imperial Oil (TSX:IMO) is at $57.50 and trading at its 52 week high, Canadian Natural Resources (TSX:CNQ) is at $46.67 and just a few dollars from its 52 week highs, Suncor (TSX:SU) is at $44.14 and also just a few dollars from its highs.

The question to ask - Can the Energy stocks hold their robust gains and advance higher when the underlying commodity prices declining?

At minimum, we can conclude that the divergence does create short-term risk in fundamentally good stocks that can be owned for the long-term.  With the current low implied volatility, buying short-term protective puts becomes an increasingly beneficial proposition.

As an example, an investor that has held shares of Imperial Oil throughout the year has participated in a $12.00+ advance from $45.00 at the start of the year to the $57.50 current highs. In consideration of the paper profits made, the investor can buy the October $56.00 put for $0.75 (as of August 28th).  For a modest cost, the investor can create a unique scenario where:

  • The investor is guaranteed a $56.00 sale price if the stock drops in reaction to deteriorating oil prices.
  • If oil prices were to bottom and begin advancing, the investor remains long the stock and continues to participate on all further gains.

In light of gains made and the divergence in crude oil prices, protecting the profits made over the short term may have some appeal to some investors.

Tax Deferral Using Options

First of all, let me preface this post with the disclosure that I am not an accountant, and it is always best to consult with one before making any investment related decisions pertaining to taxation.  That said, many Canadian investors have been benefiting from a healthy bull market with nothing more than the odd hiccup in the S&P/TSX Composite since July of 2013. Few sectors have performed as well as the Canadian banks.

Let’s take a look at TSE:ZEB which is the BMO S&P/TSX Equal Weight Banks Index ETF.  This exchange traded fund represents the value of an equal number of shares held in the 6 top Canadian banks.  As of August 21st, 2014 the holdings are as follows:

zebholdings

Below is a weekly chart reflecting the strong uptrend in the TSE:ZEB.

ZEB Weekly

Investors who took a position at the beginning of the year are up just over $3.00 per share or approximately 15%.  The consideration at this point is how to insure that this healthy profit is not lost as we move towards the end of the year.  While there is the potential for the banking sector to continue to appreciate, the potential for a healthy “correction” is always present and becomes an increasingly higher probability the more the shares continue to trend higher.

For an investor that is holding a position in a non-registered account the dilemma may be two-fold.  The first consideration,  should profits be taken at the risk of losing the benefit of further upside? The second is, that if the shares are sold, a capital gain will have to be realized for this year, which may not be in the investors best interest.

So how do you resolve this issue?

An investor who has limited expectations for further upside on a stock and wishes to lock in the profits generated at minimal cost can use a Collar strategy.  The Collar involves the sale of a call against the shares held and the purchase of a put.  In essence you are combining the Covered Call strategy with a Protective Put.

Since the investor does not wish to sell their shares this year, the strategy can be constructed using options expiring in 2015.

For example:

Currently, only March 2015 options are listed for TSE:ZEB

Prices are as follows:

TSE:ZEB shares -  $24.40

March 2015,  25 strike Call - $0.35 Bid

March 2015, 24 strike Put  - $0.85 Ask

The investor would collect $0.35 per share for the call write and use the credit to pay for a portion of the $0.85/share cost of the put.  The net cost of the Collar is $0.50/share.

With the Collar in place, the investor cannot make any gains beyond $25.00.  If the shares are trading above this on the third Friday of March, 2015 the stock will be called away. Including the cost of the Collar, this is still a 15% profit.  Keep in mind that the position can be offset in January despite the later dated expiration if the investor wishes to sell the shares and lock in the profits in the new year.

The intention of the strategy is to insure that the profits are protected.  This is where the Protective Put comes in to play.  The investor has the right to sell the shares at $24.00 regardless of how low they may drop.  With the shares of the stock at $24.40 and the cost of the protection reduced to $0.50, the maximum loss on the position is now limited to $0.90.

Regardless of how low the shares drop, the investor has locked in a $2.10 ($3.00 profit - $0.90 Collar cost) or 10% profit into the new year.  This can also be offset in January if this meets the investors objective.

The result

worst case, a 10% profit and best case, a 15% profit for holding the position into the new year.

Things to consider

There may be a little more upside to the Canadian banks leading into the fall.  With this in mind, it may be appropriate to just add a protective put expiring in December.  It will cost a little more for the protection, but the investor will participate in any continued upside while locking in profits.  As we move closer to the year end, the January options will become available and a Collar could be constructed at that point to carry the position through to the new year. Food for thought as we enter the final quarter of 2014.

Can the Canadian Bull Market Continue?

The S&P/TSX60 closed at 890.00 the other day. The market is now just 10 points away from the 900 level, which also corresponds with the 2008 all-time high prior to the great bear market that wiped out 50% of the value of the index.

This leaves many investors asking the question: will the S&P/TSX60 be able to make all-time new highs or will we see the impressive bull market advance stall out at this psychological threshold?

It is my hypothesis that in order for the Canadian market to be able to make considerable progress from the current price levels, it will have to be on the back of a new commodity bull market.

Here are the considerations that I am using to draw my conclusions:

  1. The Canadian bank and railway stocks have accounted for a very large portion of the advance, but it is unrealistic to anticipate them continuing higher at the same pace. Other sectors must pick up the slack when these stocks begin a much needed correction.
  2. The energy stocks have advanced significantly in a few short months, but is it sustainable considering the underlying commodity prices are not validating the advance.

Underlying

Year to Date Performance

Natural Gas

-9.60%

WTI Crude Oil

5.90%

iShares Energy ETF (XEG)

18.18%

If we reflect on the robust bull market advance in the Canadian markets from 2003 to 2008, it occurred on the back of a historic rise in commodity prices driven by demand from China and the emerging markets and a defined U.S. Dollar decline.

Can we witness a similar market condition? I don’t assign a high probability to it. I am sure there are a number of alternative arguments that can be made, but I consider the Canadian stock market vulnerable to a much needed market correction.

So should investors sell?

Maybe, but there are a number of problems and/or obstacles for investors and advisors. The first is the risk of exiting too soon. If an investor begins taking profits and raises cash, there becomes an increasing amount of anxiety if the market continues to advance and the bull market continues. In addition, there are a number of tax considerations to profit taking. If a market correction proves to be shallow and uneventful, the investor would have triggered unnecessary taxes and have to deal with the challenge of trying to strategically buy back into the market.

This is why it is an interesting proposition to consider S&P/TSX60 Index Options. There are strategic advantages to the European style index options. The index options are cash settled and do not involve the exercise of an underlying equity position. This ensures that no tax disposition occurs. This allows a diversified Canadian investor to hedge the downside risk of the broader Canadian markets with put options while leaving the primary composition of the portfolio unchanged. This puts the investor in a relatively reasonable position. If the markets continue to rally, the investor remains fully invested, if the market corrects or crashes, the index put hedge will substantially reduce the damage caused.

To learn more about the SXO (S&P/TSX60 Index Options) watch the video and download the PDF.

This One’s For The Blackberry Bulls

Few Canadian stocks have garnered as much attention as Blackberry LTD (TSE:BB).  In fact, it has been the topic of a few of my postings over the last year or so.  Why, you may ask?  Well, option traders love volatility. By that I mean price action, and fewer Canadian stocks deliver as much action as Blackberry.  With a historic volatility of close to 60%, this stock can deliver some significant price movement within a short period of time.

As a reminder, historic volatility is the measure of the fluctuation in share price (up or down) from the average share price over a period of time.  The higher the number, the greater the deviation from the average and subsequently, the more volatile the stock.

Blackberry shares delivered a 47% move higher from $8.50 to $12.50 from mid June until mid July.  I was amazed at how many people reached out to me when the shares were at $12.50, asking if it was a good time to buy.  This in and of itself is typically a contrarian indicator.

Beyond that, there were a couple of technical observations that indicated upward momentum was slowing and that there may be a pull back which would offer the die-hard Blackberry bull and opportunity to “buy the dip”.

Stock prices never move in a straight line and investors should never feel so compelled to take action that they can’t wait for a more favorable entry.

The recent pull back in Blackberry (TSE:BB) was largely attributed to Apple and IBM announcing an alliance to create new apps for business. This is a space that Blackberry was largely focusing on.  That said, prior to the significant drop in share price, the chart was suggesting that a pullback was highly probable.

bb_daily_july2014

It is important to note that these observations are not a 100% guarantee that the shares are going to sell off, nor does it suggest the scope or duration of the potential move. These observations simply suggest to an ambitious bull to be patient.  A trader looks to lock in profits, and with Blackberry being a “traders stock”  these observations (along with a 47% move in share value)  would be all I would need to ring the register and sell some shares.

So…now that we have seen a pull back how would I play Blackberry (TSE:BB)

To circle back to volatility, using a strategy with a limited risk on a volatile stock makes the most sense.  With the stocks historic volatility being high, the options implied volatility, which is the expectation of movement priced into the options, is equally high.  I would use a Bull Call Spread to offset volatility, reduce my cost basis, lower may break even and limit my risk in case Blackberry shares continue lower.

I would look to capture a re-test of the $12.00 resistance level by constructing a 10/12 Bull Call Spread out to September. I would do this by purchasing the $10.00 strike call and simultaneously selling the $12.00 strike call.

Prices for the options at close yesterday were as follows:

September 10 Call - $1.40 BUY
September 12 Call - $0.55 SELL

The net cost of the spread would be approximately $0.85

The profit potential is $1.15 if the shares of Blackberry (TSE:BB) are trading anywhere above $12.00 on the September expiration.

With the shares currently trading at $10.73, this spread is just shy of its break even point, which is $10.85. This is calculated by adding the cost of the spread to the purchased strike.

In my opinion, this offers the Blackberry bull an asymmetric risk/reward opportunity with a limited risk exposure on a very volatile stock.  In addition, the stock does not have to move all that much higher for the spread to break even, and only has to be trading around the $12.00 level to realize full profits.

Why I am Dumping my Magna Shares

Ok, I have to admit I used the word “dumping” to get your attention. This is not a bear rant on a good company but rather a strategic maneuver to create a favorable risk/reward proposition.  In fact, what I will demonstrate is my rationale for replacing the stock with call options.

Here are some facts about the stock:

  • Magna is currently trading near its all time new highs at $116.00 after an impressive 20 month 170% rally that started November 2012 at $43.00 a share.
  • Even after an impressive advance like that, the stock does not have valuations that are astronomical with a P/E ratio in the mid teens and a dividend just over 1%.
  • Magna’s growth rates have outpaced the industry average and continue to boost the earnings per share.
  • Technically, the stock remains in a decisive uptrend and is showing no immediate sell signals. The pattern of higher highs and higher lows is very evident and buyers use every short term consolidation to accumulate the stock.

SO WHY AM I SELLING?

First off I am not bearish on the stock, nor do I necessarily believe that a serious drop in the stock is imminent.  Rather, I am strategically adjusting my position based on the current market circumstances.

Here are some facts that I deemed important to take into account when I was assessing my situation:

  1. I own my Magna shares in my RRSP, which immediately removes the variable of tax considerations.
  2. While I did not buy my shares at the 2012 lows, I have made a considerable amount of profit in the recent advance. The consideration is that anyone that has been around the block in regards to the stock market recognizes that stocks don’t just go up in a straight line.  Rather,it is common to have numerous corrections that check an investors resolve to remain invested.
  3. The stock market as a whole is very complacent and market volatility remains historically low.  While the current option prices are deemed to be the “right price”, they are structurally cheap when compared to historical comparisons.
  4. The stock started the year at $80.00 a share and has advanced $35.00 through the first half of 2014 to its current $116.00 range.  In addition, the stock paid a $0.412 dividend on May 28th and is expected to pay another dividend in late August.

Now, I am not selling my shares to abandon the stock, but rather replacing my stock with call options to redefine a new asymmetric risk/reward proposition.  Here is what I am doing:

  • I am selling my shares of Magna at $116.00 and taking my profits in my tax sheltered RRSP.
  • For every 100 shares, I am buying 1 Magna July $115 call option for $2.30.
  • If I continue to like the position at the July 18th options expiration, I will consider rolling the call to the August 15th expiration.

So what benefit have I created?

  1. If the stock proceeds to rally to $120-$130 over the next month or two, I will continue to participate in further share appreciation by being able to exercise the call option and buy back my shares at the $115.00 strike price.
  2. If the stock continues to advance and I do buy them back, I will take ownership before the next August 28th dividend.
  3. What I have created is a trade where, under no circumstances, will I be in a position to have lost the profits I made beyond the cost of the call option.  Instead of risking an uncertain amount of unrealized profits to an unexpected market correction, I have realized all the gains and have limited my risk to the $230.00 per contract for the call options.

This may not be a consideration for all investors, but works well for the way I look and assess risk and reward in the markets.

Asymmetric Returns with a Directional Condor

The objective of any trader or investor is to achieve the greatest return for the least amount of risk.  This is what you hear hedge fund and money managers referring to as “asymmetric returns”.  One of the benefits of using options to participate in a directional view is the limited risk exposure of the purchased option premium compared to the theoretically unlimited profit potential.

An additional benefit of understanding the dynamics of the options market is the ability to create combinations that can further reduce our risk exposure while maintaining that asymmetrical risk/return structure.

The Debit Spread

In past articles we have reviewed the application of debit spreads as one such strategy.  The debit spread involves the purchase of an at-the-money option and the subsequent sale of an option at a further out-of the-money strike price.  The credit received from the out-of the-money option offsets the cost of the purchased option resulting in a lowered cost basis and break even point.  The trade off is that the “spread trader” gives up the opportunity to profit beyond the written strike for the benefit of lowering the cost basis, break even point and risk of the position. This also mitigates the impact of implied volatility contraction as well as time depreciation.  For more insight into this strategy you can review the M-X educational video on Advanced Option Strategies for Active Investors.

The Credit Spread

We have also dedicated significant attention to the idea of generating cash flow through credit spreads. As a refresher, the primary objective of the credit spread trader is to write (sell) an option contract with the expectation that it will expire worthless.  Provided that the option contract is out-of the-money on expiration all of the time value disappears and the writer keeps the premium.  The concern for some is the unidentified and theoretically unlimited risk exposure of selling “naked” options.  Don’t get me wrong, naked option writing is a powerful income generating strategy but it requires sufficient margin and the investor must truly understand and manage the risks accordingly.

To limit and identify the risk of option writing, an option contract that is further out-of the-money could be purchased using a portion of the credit received.  The credit spread trader still collects a premium, however the risk and margin required is limited to the spread minus the premium.  For more insight on this strategy you can review the Bullish Spread Strategies and Bearish Trade Strategies videos found at www.m-x.tv.

So…what happens when you combine the two?

As I suggested in the opening paragraph, we can meet all sorts of objectives by combining the purchase and sale of various option contracts. In fact I consistently maintain that the seemingly most advanced strategies are combinations of the more simple strategies.  If you understand the basics…such as debit spreads and credits spreads, you have the ingredients to construct something very interesting.

Enter the Condor

In simple terms, the Condor is constructed  by combining a debit spread and credit spread with the same expiration months.  The objective is to take a directional position using a debit spread, but further reduce the cost by adding a credit spread. This condor is named for its risk/reward profile and its resemblance to a big bird.

Condor Risk/Reward Profile

condor risk reward profile

The maximum profit of the strategy is realized when the stock is trading between the written strikes of the combination.  In this case, the debit spread is fully in-the-money and at its maximum profit, while the credit spread is out-of the-money and expires worthless resulting in the collection of the full credit.

The trade off, unlike just using a debit spread, is if the stock exceeds expectation and trades beyond the written option of the credit spread.  At that point profits are diminishing as losses are being incurred on the credit spread side.

A Practical Example with Barrick

I’m sure everyone is exhausted with gold stocks, but we are seeing some renewed interest in the mining sector reflecting an appreciation in share value across the board.  That said, there have been many false starts over the last year and traders are tentative to buy.

Barrick Gold (ABX.TO) is one of the most heavily traded stocks on the TSE and the options on the Montreal Exchange show good volume and liquidity. If an active investor felt there was the opportunity for continued upside into a specific price zone, but wanted reduce the cost of trading that view to enhance the asymmetric risk/reward potential, a condor could be considered.

The first trade

Buy the October, 18 strike call - $1.35 debit
Sell the October, 20 strike call - $0.60 credit

Net Cost = $0.75 (this is the maximum risk for the debit spread)
Max Profit = $1.25

  • This is offers the potential for a 166% profit if the stock is trading above $20.00 on expiration
  • Break even on expiration is determined by adding the cost of the spread to the purchased strike equaling  $18.75
The second trade

If the active investor expects the stocks appreciation to stall within at a certain resistance level within this time frame, a credit spread could be created above that level to lower the cost basis and enhance the profit potential even further.
Sell the October, 21 strike call - $0.40 credit
Buy the October, 23 strike call - $0.20 debit
Net Credit = $0.20
Max Risk = $0.80 ( $2.00 spread minus the credit received)
  • Break even on expiration is determined by adding the credit to the written strike equaling  $21.20
The combination

By adding the credit spread, an additional $0.20 is brought into the account.
Condor cost = $0.75 - $0.20 = $0.55
The maximum risk is now reduced down to $0.55.  This increases the potential risk/reward profitability to 263%.  This is realized if ABX.TO is trading anywhere between $20.00 and $21.00 on expiration.  The position could be closed at any point that the combination is showing a profit.  Even if the position is trading below $20.00 or above $21.00 profits are obtainable.  The difference is that we now have to consider two break even points.
Break even 1 is determined by adding the debit to the purchased strike
$18.00 + $0.55 = $18.55
Break even 2 is determined by subtracting the debit from the highest purchased call strike
$23.00 - $0.55 = $22.45
In this case the $1.45 intrinsic value of the 18/20 debit spread (gain) is offset by the $1.45 intrinsic value of the 21/23 credit spread which would be in-the-money and showing a loss.
If the stock is trading below $18.00 or above $23.00 the maximum loss of $0.55 will be realized.
The below daily chart should put things into perspective.  The main consideration is that the active investor has the expectation that the shares will be trading within the 20/21 range by the October expiration.
abx.to condor
Managing expectations

It is important to manage expectations. The probability of the stock price landing between the two written strikes on expiration for the condor to be fully profitable are less than the stock price just simply being above the written strike of the debit spread.  With that in mind, the active investor can lock in profits anytime before expiration.  All things considered, the cost of the trade has been reduced and the potential percentage rate of return has increased resulting in an enhanced asymmetrical risk/reward opportunity.

Re-visitng Past Blogs

In this Blog I occasionally follow up on previous recommendations. Taking some credit where due and blame when trades are not so successful. The idea is to engage in self-examination with the hope that it will make us better traders.

I began 2014 with the Blog “New Year Optimism” where I talked about the possibility that the North American economies may actually be in better shape than many analysts believed. Any pick-up in US activity, which I still think is a second half story, would likely benefit Canada’s transportation sector.

Specifically, I suggested buying July 60 calls on Canadian National Railway (CNR) at $2.75 or better. The CNR July 60 calls closed Friday at $5.75 (up 109%). I also suggested buying the Canadian Pacific (CP) July 160 calls at $10 or better. The CP July 160 calls closed Friday at $22.25 up 122.5%. So far so good.

In March I revisited gold stocks (March 10-2014 – “Where’s The Glitter?”). Something I do from time to time for reasons that escape me. I’m kidding, of course, although I have never really liked this sector aside from employing option writing strategies on the individual equities. In the March Blog I suggested writing the Goldcorp July 28 puts at $1.60 or better. At the time, Goldcorp was rallying and I did not want to jump on the bandwagon. The idea was to buy shares at a lower price because I thought many gold stocks may have put in a medium term bottom… Goldcorp included. The stock briefly touched $30 per share and then fell as inflationary expectations waned. At the end of trading on Friday, the Goldcorp July 28 puts closed at $2.78 for a loss of -42.45%. Not so good, although with this position I would simply take possession of the shares and write an at-the-money call ou,t say, three months.

On February 28, 2014 (“Blackberry Resuscitated”) I revisited an iconic Canadian brand trying desperately to survive. The latest strategy being Blackberry instant messaging (BBM for short) ,which had gained some traction among tech aficionados. But so far the company has not been able to monetize BBM to the point where it sparks any enthusiasm that a turnaround has begun. In the February Blog I suggested that anyone wanting to hold Blackberry consider writing covered calls against the position. It was a general point of view with no specific suggestions. The stock has drifted lower since February and those who employed the covered call strategy have at least had some downside protection and cash flow. If you remain a fan of Blackberry, I encourage you to keep writing the covered calls. Sometimes even the most loyal follower has to accept the reality of the situation.

Insurance for your Insurance Stocks

For any keen market observer, it is hard to have missed the relative under-performance of the Canadian insurance stocks vs. the Canadian bank stocks. This divergence comes to a surprise to many investors that felt the stocks would rise together in the pronounced bull market.  So what could be some of the underlying precipitating factors that could be driving the divergence in performance?

Macro Factors - Interest Rate Trends

In the world of zero interest rates and modest equity returns, insurers have to contend with considerable macro factors that relatively increase sensitivity to their earnings and balance sheets.  Given the long duration of actuarial liabilities, there are a decreasing number of similar duration investments offering the yields necessary to not create company risk.

What if the broad consensus of higher interest rates is proven to be premature?  What if the recent declines in interest rates, driven by pending new QE programs in the Euro zone, leads to a new pronounced decline in interest rates?  Will the insurance stocks wear the lepers’ bell in fear that that current valuations were simply pricing in an unrealistic Goldilocks economy?

Technical Vulnerability

Unlike the resounding uptrend that many Canadian Bank stocks share, the insurance stocks are lagging and on the verge of breaking the 2014 year lows.  If the insurance stocks technically break, it could lead to new selling pressure that could drive short-term weakness.

The first instinct is for an existing investor to respond two ways: either they immediately fall back to rationalizing that they are long-term investors and that everything will be fine over the long-term.  The alternative reaction is for someone to rush to sell the insurance stocks and reinvest into another sector.  I would like to debate a 3rd alternative of creating a short-term hedge using a put.

For this example, we will use Manulife (TSX:MFC)

  • Manulife made its year high on January 22nd at $22.22 CAD.
  • Manulife is trading near its year low at $20.00.
  • At its lows in 2013, Manulife traded in the $14.00 range.

While the optimist will suggest that the stock may continue to appreciate, the pessimist will be quick to observe that there remains vulnerability for the stock to decline towards its 2013 trading ranges. The question to be debated – does the potential profit opportunity outweigh the downside risks? An investor utilizing a protective put can let the market make that decision for them.

Example of investor utilizing a protective put on Manulife:

  • Investor owns 1000 shares ($20,000) of Manulife (currently $20.00 May 28th)
  • Investor is concerned about the short term technical weakness and relative under-performance.
  • Investor buys 10 July $20.00 put options for $0.50 or $500.00

The investor now has created a short-term plan to deal with the long-term.  The investor with the protective put has now been able to remove the risk of an immediate technical breakdown as they have secured a guaranteed exit price at $20.00 until July 18th.  Now if Manulife was to technically break, the investor can exercise their right and sell the underlying at $20.00.  Alternatively, if Manulife was to be able to turn bullish and begin an advance back toward the 52 week highs, the investor can continue to own the stock and let the protection expire.  Some investors may find this a reasonable alternative to having to make an immediate sell or hold decision.

Tim Hortons - Value or Growth?

The Company is a Canadian icon. Like Canadian Tire, Hudson’s Bay and even the Timothy Eaton Company once Canada’s premier department store.

Despite the familiarity of these brands in Canada there has been little evidence that Canadian brands carry any weight south of the 49th parallel. Canadian Tire being a case in point. That company tried to move into the US during the 1980s with no success. Quickly abandoning the strategy before it caused irreparable damage to the company.

I raise this issue because Tim Hortons (symbol THI, Recent price $59.98) is embarking on a similar strategy and for me at least, it is not clear it will be successful. When you think about it Wendy’s once owned THI and they sold the company because it could not penetrate the US market. I have little confidence that THI management as a standalone entity will fare any better.

In my view there is simply too much competition in the US – Dunkin Donuts, Starbucks and even McDonalds with their McCafe franchises – that have brand loyalty similar to THI’s success in Canada. My concern is that the company is basing a large part of its growth strategy on its US initiative.

Now to be fair THI is also expanding into Western Canada which I believe has a good chance of success. The problem may be in how much of the company’s resources get tied up in their US experiment and whether or not that will cause growth to come in less than what the market has priced into the company.

So I am torn. I like the company’s long term potential but over time I think the market will begin to value the company as a mature business rather than a higher multiple growth story. If so then we are talking about excellent cash flow which will have to find its way back to the shareholders in the form of higher dividends and stock re-purchase programs.

Given that I would argue that this is a solid company that deserves a place in ones’ portfolio but with a set of metrics that focus on value. Understanding that the PE might contract as the market shifts its focus from growth to value! In that scenario you might want to look at option strategies that limit upside potential but provide enhanced cash flow.

For example you might look at implementing a regular covered call strategy against part of your THI exposure. With THI near $60 per share the sale of the at-the-money June 60 calls at $1.00 per share or better look interesting as a starting point. Should they expire worthless write new calls with a one to two month window to expiry.

European Central Bank QE and the U.S. Dollar

Last Thursday Mario Draghi confirmed the suspicions of many…that the European Central Bank was preparing a Quantitative Easing type policy package for its next meeting scheduled for June. Considerations will include cuts in interest rates and other measures with a focus on stimulating lending to small and medium size business.

It should be noted that the European Central Bank (ECB) has yet to suggest a “money printing” program that would be comparable to the U.S. Fed solution to introducing stimulus to the economy.  Regardless, the impact on the Euro based on their statement of intentions was swift. The Euro began selling off and continues to show signs of weakness.

Since currency is based on a FIAT system where one currency is only worth it’s value comparable to another currency, we have subsequently seen the U.S. Dollar jump on the news.

So the question is whether we are now about to see a “tipping of the scales”  between the U.S. Dollar and the Euro?  If we believe in the “currency Wars” theory ( an interesting read by James Rickards)  which suggests that countries are competing to devalue their currency in a bid to stimulate foreign investment, and increase manufacturing for foreign export… then it makes sense.  This has been the mandate of the U.S. for the last several years. With it looking as though they are slowing down their “easing” it makes sense that we see a swing towards the Euros devaluation.

We can’t necessarily assume that this move by the ECB will facilitate a move higher in the U.S. Dollar and it’s relationship to the Canadian Dollar.  However, it is in Canada’s best interest economically for the Loonie to remain cheaper than the U.S. Dollar.  With Canadian interest rates likely to remain low for years to come according to Bank of Canada’s Stephen Poloz, there isn’t likely to be anything to stop the U.S. Dollar from continuing to appreciate against the Canadian Dollar.

If you have an expectation for the U.S. Dollar to continue its uptrend against the Canadian Dollar you could participate by purchasing USX call options.

USX options are priced based on the U.S. Dollar relationship to the Canadian Dollar.  1 contract provides exposure to US$10,000.00.  The purchaser of a USX call option has the potential to profit if the U.S. Dollar increases in value against the Canadian Dollar with in the time frame selected.  The final settlement is based on the difference between the strike price selected and the Bank of Canada noon rate on the expiration date.  If the call is in-the-money, the option will be settled in Canadian Dollars otherwise, it will expire worthless.

To understand the strike prices as they relate to the actual spot market you multiply the spot market rate by 100.  For example, with the spot market rate currently sitting at 1.0893, an at-the-money USX call strike would be 109.  for more information on USX options you can watch this video Introduction to Currency Options or download the .PDF file.

Regardless of my assumptions, I always want my technical observations on the price chart to confirm my fundamental expectations.  With that in mind, we can take a look at the daily chart of the USD/CAD and make a few observations as well as set some “rules” in place to identify a when it might be time to take action.

1. Potential Declining Wedge forming indicating a pause in the prevailing uptrend for the USD.  This formation is known as a continuation pattern indicating that the USD has a high probability of moving higher
2. A close above the cluster of moving averages (8,21,62) at approximately 109 confirms a that USD/CAD shorter term prices are beginning to trend higher than the longer term average
3. Stochastics Oscilator indicates overbought/oversold conditions.  The chart below show stochastics  oversold and building momentum for a move higher

USD/CAD Daily - May 20, 2014

If you are confident in a continuation higher in the U.S. Dollar against the Canadian Dollar, a September, 109 call option could be purchased for approximately 1.36 or $136.00 per contract.  This would put your break even point at a spot market exchange rate of 1.1036 on expiration.  Keep in mind that you can close the position at any time to lock in profits or cut losses.