Is Volatility Gone… or Just Forgotten?

In an environment where we see sluggish growth among industrialized countries, global deflation, weak oil prices, political indecision in the US and negative interest rates, one could argue we are living in the worst of times. Add to that mix company specific events like missed earnings and questionable government regulation and we have a classic tug of war between bulls and bears. More worrisome to me is the undue influence that company specific events are having on the broader market.

I say that because one would think in such an uncertain environment that option writers would be generating well above average returns. No so much! Mainly because uncertainty in the broader markets and even among the sectors, is not being translated into higher option premiums. Leading one to ask, is volatility gone, or just forgotten?

The Canadian Volatility Index (symbol VIXC) closed Friday at 12.73 near all-time lows and 30% below its 200 day moving average. The VIXC measures the volatility being implied by a cross-section of options on the S&P/TSX 60 index. A low VIXC implies low option premiums, a higher the VIXC; more expensive options. How can volatility be so low with so much global uncertainty?

Before we examine that, it is important to review the ground rules. Traders need to understand that there are six basic components within the option pricing equation. Most importantly is the relationship between the strike price of the option and the current price of the underlying stock. Are we, for example, trying to value an in, at, or out-of-the-money option?

We also plug into the formula, the time to expiration. The longer the option has to expiry, the more value it has. Keeping with the time to expiry theme, traders need to be able to value the cost of carry associated with competing option positions. Cost of carry brings dividends paid (if any) and the risk free rate of interest into the model.

Finally, we plug into the formula an assumption about volatility. The more volatile the underlying stock or index, the better the chance that it will move in the direction necessary for the option to become profitable.

Volatility is seen as the most important consideration when pricing an option because it is the only factor in the pricing model not given, and therefore, must be estimated. In many cases, traders plug all the factors into the formula including the current price of the option. Rather than asking for a theoretical fair value for the option the formula solves for volatility… referred to as the options implied volatility.

Implied volatility is simply the option market’s attempt to quantify the risk given current market conditions. Presumably, the greater the uncertainty, the higher the implied volatility which by extension, means higher option premiums. In the current environment we are witnessing a serious disconnect between option premiums and uncertainty. At least among index options.

Normally such disconnects precede a major market move one way or the other because option traders are notorious at underestimating future volatility. Often bidding up premiums too far after a major move or driving premiums too low during periods of market consolidation. The easiest thing is to dismiss the current disconnect as simply another case of traders misdiagnosing the market. However, it may be more than that.

When you think about option premiums and how it reflects risk, you can break that down into three components; market, sector and company specific risk. Because the S&P/TSX 60 index represents a broadly based portfolio, it is only measuring market risk.

Specific sectors are less diversified, and reflect both market risk and sector risk. We would expect premiums on sector indexes to be higher than would be the case for more broadly diversified market indexes. We see that differential play out in sectors like energy and precious metals. That said, even among sector indices, we are seeing historically low levels of implied volatility.

What appears to be happening is that investors are shifting attention to company specific issues. The implication is that we are in an environment where company selection is significantly more important than market direction. I say that because investors seem to be willing to pay up for options on individual companies, believing that company specific events will dictate market movement over the near term. Something that historically at least, is not consistent with longer term trends.

That leads me to think that the future will sting investors with a significant market move – up or down – that will shift attention away from individual companies and back into the broader market or specific sectors.

In the interim may I humbly suggest that you review your positions and at the very least make certain that your current portfolio of individual stocks is hedged and diversified?

Covered Call Horror Stories

In the late 1990s I sold a covered call on, let’s call the security, XYZ. A “nom de plume” to protect the guilty… or innocent, depending on your point of view.

In any event, XYZ was a particularly volatile technology company trading at $21.75 per share in January 1998. I bought the shares for myself and clients and immediately sold January (1999) 22.50 calls at $4.75 per share. Looked pretty good when I entered the trade. The one year return assuming XYZ was called away, came in at 32.3%.

A much better return than the TSX composite index with significantly less risk as it turned out. To be fair, I need to qualify what I mean by less risk. Investors do not view risk in terms of volatility but rather focus on downside risk which equates to the likelihood of losing part or all of one’s initial investment. At least initially!

By the summer of 1998, XYZ was trading in the high 60s. The risk of loss at this price point is virtually eliminated and that triggers an interesting transformation. With risk off the table the focus shifts to performance or the lack thereof.

As a portfolio manager I had positioned myself and clients into a stock that beat the market, did so with less risk, and yet by the end of 1998, the most frequent comment I heard was; “I wish we hadn’t sold calls on XYZ!” I can’t tell you how many times clients looked at their accounts and saw the performance of XYZ, only to see an offsetting position in the XYZ calls. And perhaps, in hindsight, they were right. Maybe it was a mistake to have sold the calls on XYZ. And there lies the rub!

That’s risk with covered call writing is that you end up losing the best performing stocks in your portfolio. Sometimes at a fraction of the underlying securities market value when the options are exercised. By January 1999, XYZ was trading at $83 per share only to be called away at $22.50. Brought tears to my eyes!

The XYZ example, however painful, provides us with three basic principles; 1) never forget the reasons for selling the option in the first place, 2) always recognize that a covered call writing can and often does, eliminate the best performing stocks in your portfolio and 3) ask yourself, if there are follow up strategies that could enhance the returns from the original position.

As for a follow up strategy bear in mind that we are not looking to repair a losing position but rather, are looking for ways to enhance the performance metrics when the underlying security breaks through the strike price of the short call.

To that point the most common follow up strategy is the bull put spread. A bull put spread involves the sale of a put with a higher strike price, and the purchase of a put with a lower strike price. The position is established with a net credit, and does require margin. Assuming the initial covered call write was paid for in full, you may not be required to post additional capital in order to implement the bull put spread.

In the XYZ example, when the shares were in the mid-30s I could have executed an XYZ January (1999) 40 – 30 bull put spread. Most likely the spread would have generated $3.50 per share net credit which, in hindsight, would have doubled the performance.

But I suspect from years in the trenches, it would not have been enough to placate clients who simply felt violated having to sell their shares at 25% of the value they were trading at in January 1999.

Buying the Dip on the Gold Miners

It is fair to say that gold mining stocks have been the most volatile sector in the market through 2016.  Using the iShares S&P/TSX Global Gold ETF (TSX:XGD) as an average of the industry, 2016 has seen a staggering 133% rise over the first half of the year and now (through the month of August), a 20% decline from the highs.  So how does an investor interpret the situation and what can they do?

While there are an infinite number of opinions, the majority can be lumped between two key narratives:

  1. Gold entered into a new bull market and you must buy every dip.
  2. Gold has rebounded from extraordinarily oversold conditions, but within a macro environment of deflation and a strong U.S. dollar. Moving forward, gold may simply fall back to the bottom of it’s ranges and the opportunities have past.

So how does one position themselves? That is where using options gives investors many alternatives beyond a simple buy or sell decision. In this case, I want to feature a simple strategy an investor can consider in positioning themselves on gold stocks.

In these examples we will use the iShares S&P/TSX Global Gold ETF (TSX:XGD) which, at the time of writing, closed at $14.27.

Long Stock Hedged with a Put

One basic strategy an investor could consider is buying the shares at the prevailing rate and buying a protective put to insure the downside risk.  This allows the investor the opportunity to buy the dip and have some certainty that the downside risk is predefined.  Let’s look at an example:

  • Investor buys 1000 shares of XGD at $14.27 or $14,270.00
  • Investor proceeds to buy 10 put options at the October $14.00 strike for $0.70 or $700.00

Let’s explore the possible alternative outcomes and choices the investor will have over the subsequent 6 weeks.

Scenario 1 – Gold Miners Rally

In this scenario, this pullback in gold proved to be a buy on dip opportunity.  The XGD proceeds to rally back toward the year highs and the investor has a new position at an average cost of $14.97 ($14.27+$0.70).

Scenario 2 – The Gold Miners Continue Declining

In this scenario, the XGD declines further and returns to the $10.00 level where shares traded back in March 2016.  Our investor has two choices at that point:

  1. Exercise their right to sell the shares at $14.00 and simply walk away accepting a $970.00 loss on the position
  2. Exercise their right to sell the shares at $14.00 and subsequently use the $14,000 in proceeds to buy 1400 new shares back at the prevailing $10.00 market price.

So what observations can one make when observing the alternate scenarios?  The one that particularly resides with me is that the investor was able to take a decisive risk, define that risk, and if wrong or early to the trade, had a number of choices on how to proceed.  That offers the investor considerably more control then the binary choices of buy or sell.

The Doubling Strategy

This week, rather than looking at short term trading opportunities, we will examine a longer term strategy that is not dependent on a directional bet for the underlying stock. What it comes down to is positioning. Is this a stock you would be willing to hold longer term, what role will it play in your portfolio (i.e. risk reduction, return enhancement, etc.), what cost is reasonable? Assuming you are comfortable holding the underlying stock and have a rudimentary understanding of the role it will play in your portfolio, options can address acquisition cost.

The acquisition strategy is a covered combination on a volatile stock that is designed to take advantage of dollar cost averaging. A volatile stock has a greater impact on the range of outcomes for the strategy. In much the same way as volatility enhances the outcome when acquiring a position through dollar cost averaging.

To that point we’ll focus on two examples; Goldcorp Inc. (Symbol: G, Fridays close $20.75) and Valeant Pharmaceuticals (VRX, $40.14).

Company specific issues aside, the case for Goldcorp rests almost entirely on your outlook for gold. If that outlook is positive and you want to increase exposure to gold in your portfolio, the covered combination is an excellent way to manage the acquisition of shares.

We’ll assume for example that you are comfortable owning 1,000 shares of Goldcorp in your portfolio. We begin by purchasing 500 shares of Goldcorp at $20.75. We immediately sell five Goldcorp January (2018) 21 calls and five January (2018) 21 puts for a net credit of $8.60. Note these options expire in January 2018, which is seventeen months from now.

At the January 2018 expiration one of three outcomes will occur; the stock will rise above $21, fall or stay the same. If Goldcorp is trading above $21 in January 2018, the Jan 21 puts will expire worthless and the Jan 21 calls will be exercised. Under this scenario you would deliver your initial 500 shares to the call buyer. Your out of pocket cost to buy the initial 500 shares was $12.15 ($20.75 less $8.60 in option premium = $12.15). The seventeen-month return on the initial position would be 72.8%. This assumes of course that you are using margin rather than cash to secure the short puts and does not take into account the seventeen monthly dividends that you would receive while holding the shares.

If the stock stays the same or declines, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 500 shares of Goldcorp at $21.00 per share. At this point you would have acquired your 1,000 share objective at an average cost of $16.575. You should be comfortable holding 1,000 shares of Goldcorp at the average acquisition cost.

Now to Valeant Pharmaceuticals whose options options are trading in the top quartile of implied volatility. The high premiums are reflecting market concerns over management missteps. But, if you believe that past missteps are a sign post and not a hitching post, and believe this is a stock that can enhance longer term performance within a diversified portfolio, the covered combination can play a valuable role.

We’ll assume you are looking to acquire 400 shares of Valeant. We begin by purchasing 200 shares at $40.14. We immediately sell Valeant April 40 calls and April 40 puts for a minimum net credit of $18.50. These are not liquid options so be sure to use limit orders.

At the April 2017 expiration Valeant will be either above or below $40 per share. If Valeant stays the same or rises, the April 40 puts will expire worthless and the April 40 calls will be exercised. Under this scenario you would deliver the initial 200 shares to the call buyer. Your out of pocket cost to buy the initial 200 shares was $21.64 ($40.14 less $18.50 in option premium = $21.64). The eight-month return on the initial position would be 84.8%. Again assuming margin rather than cash is used to secure the short puts.

If the stock declines below $40 per share at the April expiration, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 200 shares of Valeant at $40.00 per share. The average cost for the 400 shares would be $30.82. You need to be comfortable with the average cost base for the 400 shares.

Covered Calls versus Naked Puts

Covered call writing is a low risk option strategy. If the underlying rises above the strike price the calls are assigned, you deliver the shares and exit with the best case scenario.

Covered calls make money in a rising or flat market and because the premium received reduces the cost of the underlying shares, is less risky than an outright long position in the stock.

Maximum return is at the strike price of the call, maximum risk occurs if the underlying declines to zero. Although to be fair, maximum risk is a function of the underlying security not the strategy.

Now look at naked put writing. Characterizing any strategy as “naked” implies risk. One is not “covered” by a long position in the underlying but rather is taking on a commitment to buy shares at a specific price for a pre-determined time period.

But here’s the rub; If the naked put writer secures the obligation with cash (i.e. cash secured put) is the strategy riskier than covered calls? Maximum return occurs at the strike price, maximum risk if the underlying decline to zero. In short – pardon the pun - covered calls and cash secured puts are equivalent positions.

So what leads an investor to employ one position and not the other? One reason is the regulatory environment which does not allow the sale of puts inside registered plans (i.e. RRSPs, RRIFs, RESPs, TFSAs). Simply stated the inherent obligation to buy whether secured with cash or not, requires margin. Registered plans are not marginable.

You have to be approved for a higher level of option trading when executing naked option positions. And there are good reasons for that! Put writers tend to leverage their exposure to an underlying security. Cash secured positions are not set in stone because you can always tap the cash being used to secure the position. Very different from the covered call writer who would have to sell shares in order to raise cash.

On the positive side a cash secured put can be executed with a single trade… one commission, one bid ask spread. That can be useful if you need to exit a losing position.

It can also benefit when trading positions on foreign markets. If you buy a dividend paying US stock you are subjected to withholding tax on the dividends and foreign exchange risk on the entire position.

If you write a put to buy a US stock and secure it with case held in Canada, you eliminate most of the foreign currency risk. Also the put premium takes into account any dividends payable by the underlying security.

Once a short put position is established be mindful of certain twists like the erosion of time value. Typically, time value for in-the-money puts erodes more rapidly than for in-the-money call options. And while that can be an advantage the rapid erosion of time value on in-the-money puts increases the likelihood that the puts will be assigned early. That happens more often than not particularly if a dividend payment is imminent.

So despite the fact that covered calls and naked puts are equivalent positions it is important to understand the subtleties associated with each strategy.

The Divergence in Oil and Oil Stocks

Something weird is happening in the energy markets… Oil and gas stocks seemed to stop caring what oil is doing.  The divergences are staggering.  What do I mean? Back in May, when crude oil was at its $50+ peak level, there was jubilee amongst investors. It has become consensus that oil has not only bottomed but is discovering a new range in the $45-$60 range to bring stability back into the battered energy markets.

How did investors react?  They bought up the senior energy companies like it was the buying opportunity of a life time.  With no bias, I will utilize the shares of Canadian Natural Resources TSX:CNQ (Referenced as CNQ).  I can assure you that investors who did buy CNQ at $22.00 a share are feeling good about themselves, but I have to ask, does that make it safe buying new positions at $40.00 a share today?

Naively, I am going to make a basic observation as to what price levels CNQ traded at as compared to crude prices.


WTI Crude Oil Price $

Canadian Natural Res (CNQ)

February 10, 2014



October 6, 2014



April 30, 2015



July 29, 2016



Maybe I am missing something, but I just cannot bring myself to justify paying $40.00 a share for CNQ, when it represents the same price that the stock traded when crude oil traded 50-100% higher than it is today.

What could some of the factors be driving the divergence?

1. Lack of alterative value sectors - Back in January 2016, many of the senior oil companies were trading at levels not seen in decades, discounting some extremely bearish outlier scenarios.  This drove value investors, and later momentum and technical traders to follow.

2. Search for yield - With bond yields collapsing to historic lows, income investors have been starved for yield.  Once it became clear that many senior oil companies were not going to cut their dividends (at least not initially), investors could not help themselves trying to catch a potential bottom.

3. Index weighting - The Canadian S&P/TSX60 is 20.38% weighted into energy (July 29,2016).  After the January 2016 lows, domestic and international investors were buying the Canadian market broadly looking to participate in a potential bottom in the resource markets.  This broad index buying weighs money into energy irrespective of current macro fundamentals.

What has this created?  A market where oil stocks are trading at price/earnings multiples that are normally reserved for high growth tech companies. Observe the chart below.

So what could an investor do beyond outright selling everything?  Hedge!

After such a strong run higher, any investor that has bought an energy company over the last 6 months is likely profitable or close to it.  This is when buying a protective put with some of the profits may be a solid alternative to selling.   The buying of the put option ensures that you locked in a guaranteed sale price, allows you to continue to collect the dividends and prevents you from incurring a tax disposition in the sale of the stock.

When you own a put option, it gives you the control in the decision to exercise the right to sell. Alternatively, if profitable on the put option, the investor can simply monetize the profit.  At minimum, for investors that are new to options, it is worth knowing all the alternative investment choices beyond just the traditional buy/sell trading decision.

Writing Calls Against ETFs

When most investors think about selling covered calls, they think in terms of writing calls against individual stocks. Less often we think about writing covered calls against exchange traded funds (ETFs). Too bad really, because there are some interesting opportunities in that market space.

Trading ETFs reduces the impact of company specific risk which is defined as an event that can affect a company without necessarily the sector or market. Drug trials being a classic case where the success or failure of a particular drug can impact the sponsoring company with little or no effect on the sector.

While traders are pretty good at evaluating risk in a sector or the broader market, individual corporate risks are, for the most part, unknown. Which means the option market cannot quantify these risks! And that itself is a risk because a material event can exponentially impact the value of the underlying stock.

What tends to happen is that options overstate risk within sectors and the broader market while understating risk among individual companies. Proof can be seen in the performance of the Mx Covered Call Writers (MCWX) Index.

The MCWX is a benchmark that tracks the performance resulting from the rolling sale of one month at-the-money calls against a long position in the iShares S&P TSX 60 ETF (symbol XIU). With data back to 1992 we see that the options market has regularly overstated the actual historical volatility of holding XIU.

It makes sense that index option buyers tend to overpay. There is only one decision to make; are you bullish or bearish on the market? No second guessing about which sectors will outperform or which stocks within a sector will stand out. And of course, no risk of being blindsided by a material event that could not possibly be predicted.

Another consideration is downside risk. Individual companies can go bankrupt, ETFs cannot. That zero is never the worst case scenario is a positive for the covered call strategy. Bottom line covered calls on ETFs provides better risk reward metrics.

The challenge with selling ETF covered calls in Canada is liquidity constraints on many of the names. Still there are opportunities with enough liquidity to trade. Particularly within sector ETFs. For example, you might look at writing covered calls on iShares S&P/TSX Capped Energy Index ETF (XEG), iShares S&P/TSX Global Gold Index ETF (XGD) and iShares S&P/TSX Capped Financials Index ETF (XFN).

Of Mice and Men and Rolling Options

As anyone who has ever traded knows, the best laid plans pften go awry. Before making any adjustments, the investor needs to dissect what went wrong. Does he or she still hold fast to their original forecast but has simply run out of time, or was the strategy selection itself incorrect% Remember that closing the position full or cutting down the size of the position are always valid choices.

Read full article here: Of Mice and Men and Rolling Options

Managing Risk

There are many factors one should think about when making specific investment decisions. Momentum, sentiment, fundamentals, quantitative metrics, value models… the list goes on!

That said successful traders share a common thread. They have established principles for selecting the right stock, strategy or position and are able to manage risk once the position has been established.

It comes down to a recognition that financial markets reward different strategies at points along the business cycle. Sometimes covered calls make the most sense, other times buying calls is the preferred strategy. Volatility trades make sense when volatility troughs or expands dramatically. Leverage is useful at certain stages while other times hedging is a better approach.

Think of these strategies in terms of “risk-on-risk-off”! The point being, reasonable investment strategies will profit at some point of the market cycle. The trick is managing risk during periods when the market is not rewarding your selected strategy.

How you manage risk depends to a large extent on whether you are a trader or long term investor. Traders need to think in terms of cutting losses and letting profits run. Long term investors tend to set reasonable targets for selling and often will hold or average down a losing position assuming the fundamentals have not changed. In theory, if XYZ was a good buy at $50 it must be a screaming buy at $40.

Since this is an option blog we assume most readers are active traders. As such, averaging down takes a back seat to cutting losses. Not to mention the time constraints and volatility expansion that accompanies a losing option position. Setting upside price targets is equally irrelevant as it goes against the grain of letting profits run.

A better approach is to think about new positions in terms of risk. How much downside will you undertake in a particular position? Stop losses are one approach but not particularly effective with options. A better mathematical approach is to use percentage moves as your line in the sand.

To that point think about a long call position. Since a long call has limited risk, the most you can lose is 100% of your investment. On the other hand, you can gain more than 100% on a winning position. So your starting point should be 100% downside more than 100% upside.

The challenge with long option positions is the erosion of time value. That’s a constant which means that your losing positions will likely outnumber your profitable trades. Given that it makes more sense to apply a tighter downside band than upside boundary. Think about exiting a long position if it declines by 50%. If you paid $5.00 for a call you would close the position if it fell to $2.50. As for the upside the 100% gain should be the demarcation line. Look to start exiting when the position has gained 100%. At that point you might swell half your position. Easier to let profits run when you have no capital at risk.

Another approach if you believe the momentum will continue, is to roll up a successful trade. Sell the initial position at a 100% or better profit and roll up to a slightly out-of-the-money call to take advantage of further upside. Rolling up means entering a new position following the same criteria of the initial position; sell if losses hit 50%, continue to hold until profits hit 100%.

If you prefer option writing strategies take into account that time is now on your side. However, when writing puts or uncovered calls your downside could be greater than 100%. Limiting the downside to 50% becomes critical.

Covered call writing is another common strategy where cash management plays an important role. With the covered call you own the underlying shares. You should have a much tighter line in the sand for cutting losses should the stock decline. As a rule of thumb think about cutting losses if the stock declines 20%. Since this is a covered call, a 20% loss on the stock is probably less than a 15% loss on the overall position.

Managing risk for an active trader is based on a set of mathematical probabilities. The downside triggers require discipline and the emotional makeup to admit a mistake. More importantly you cannot abandon the math should one of your exited positions whipsaw into profitability. Past trades should be a sign post not a hitching post.

Investors Options Trading Letter - June 2016 Issue