Understanding Credit Spreads and How they Differ from Debits Spreads

In a previous posting, we learned how to implement a debit spread for both calls and puts. This week, we will examine another form of vertical spreads: credit spreads and how they can be used.

Understanding Credit Spreads and How they Differ from Debit Spreads

Brexit is a reality!

Brexit is a reality! Despite the betting odds, despite the financial markets’ expectation that we would see a “remain” outcome, the British electorate knowing for bucking the odds voted to exit the European Union.

And now we face the inevitable fallout. Unfiltered headline noise will set the stage this week. Witness the latest hot off the press headline noise; “Financial Markets in Free Fall;” “Volatility is Spiking;” “Gold is Surging;” “Currencies are in Disarray!” Remember this is noise and not what you should focus on when making investment decisions.

Fact is Canadian equities as measured by the iShares S&P/TSX 60 Index Fund (symbol XIU) fell 1.93% on Friday which puts the index back to where it was a week ago. The so-called spike in volatility is well below levels in February (the MX VIX Index closed Friday at 20.06, it closed as high as 31.99 in February this year). Gold is higher but not as much as you might think and is still well below levels from 2012 through 2014. Gold bugs are not seeing this as the global crisis that financial writers and doomsayers like to espouse.

The currency market is another story. The decline in the British Pound was monumental, clearly uncharted territory! And there may be more to come. Britain will most likely slip into a recession which may prompt Mark Carney head of the Bank of England to cut rates. Best guess is a snap 25 basis point cut which may further weaken the pound.

I believe the longer term implications will be political than economic. British Prime Minister David Cameron orchestrated this vote based on a promise he made to parliament in 2013. It was designed to appease members of his own party who felt that Britain gave up too much in negotiations with the EU. The lesson from this is that referendums don’t work well when dealing with complicated positions. Too often the economic message gets lost under the weight of political biases that gravitate to the lowest common denominator. In this case the leave camp played on the electorates’ xenophobia about lax immigration policies, unprotected borders and jobs. If you think that’s not the case watch closely as the US Presidential race heats up. It will play to the same storyline.

The trick in the weeks ahead is to separate the political meat from the skeleton. For example, the Scottish Parliament fresh off their own referendum that voted to remain within Britain mainly because doing so allowed Scotland unfettered access to the Eurozone, will probably introduce legislation to prevent the British parliament from enacting article 50 (the article that provides the process for exiting the Eurozone) with Scottish consent. It won’t matter but that will likely lead to another Scottish referendum to leave Britain which may well pass.

Northern Ireland will attempt to succeed from Britain to join Ireland which is an EU member. That will not likely pass muster with the Protestant majority in Northern Ireland, but will nevertheless be fodder for more headline noise.

Conspiracy theorists will say that the British exit will lead to more separations within the Eurozone. That’s not likely with the possible exception of Hungary. But that will have more to do with the political system. Hungary is a dictatorship and under the rules, only democracies can be members of the Eurozone. As for Italy, Spain or Greece, if they were going to leave they would have done so already.

I suspect that reality will begin to set in by mid-week. Any exit plan will take two to three years to implement. Most likely Britain will negotiate a partial union much like currently exists for Norway which pays about US $1 billion in annual dues to have access to the Eurozone. Norway must follow Eurozone rules but as a country remains independent.

As cooler heads prevail we may well see a rebound in equity markets once hedge funds and institutional portfolio managers have reset their portfolios based on revised earnings expectations. Which by the way will start to replace the headlines starting in July.

At this stage I would avoid committing serious money to hedging strategies. I think most of the damage has already occurred. Wait for opportunities to begin nibbling at new positions which could come as early as mid-week.

Richard N Croft

Gold versus Gold Stocks

Gold has been on a tear recently. Not because of any real change in supply demand metrics. This is all about defensive positioning against a perceived devaluation of paper currency. In short gold bulls are playing the crisis insurance card… again!

I am not about to tell you to buy gold. I’ve talked about it in the past but to be frank there are enough writers willing to talk gold up. Many with solid reasons supporting their position. So let’s assume that you should have some gold in your portfolio. The question I want to tackle is whether you should gain exposure through gold or gold stocks.

The most basic argument would tell you to bypass the producers and hold bullion. You can gain exposure to bullion through ETFs or for those who prefer tactile pleasures, you can buy the actual bullion from your local bank.

When buying gold mining stocks you are assuming risks beyond gold’s price action. Miners are susceptible to company specific events like labor unrest, management expertise or lack thereof, leverage and margins which can impact your investment in up and down markets.

To add some meat to that last point, many gold miners engage in hedging strategies. As such rising gold prices will not necessarily result in better margins if management has hedged the company’s forward production. On the flip side, hedging strategies benefit investors by maintaining margins during periods when gold’s price is declining.

Since I typically move in and out of gold as a momentum play I tend to gravitate to gold miners. As a momentum play miners should move more dramatically because of the aforementioned leverage. At the most granular level, miners are in the margin business where proper analysis can assign reasonable probabilities. That’s easier than trying to explain the hedging dynamics used to talk up gold’s price during periods of financial uncertainty.

The fact that miners tend to be more volatile adds another twist when viewed in terms of the options market. Higher volatility translates in higher option premiums which can be useful when looking at option writing strategies.

For example, suppose you are looking for some exposure to gold as a hedge. Using miners you could write covered calls. As a case in point consider Agnico Eagle (TSX: AEM, Friday’s close $64.69) where we could buy the shares and sell the August 66 calls at $4.30. If AEM is called away at $66 per share the net two month return on the position is 8.6%.

Now let’s look at buying gold bullion trading at US $1,286 or CDN $1,650, as our hedge. To get the same two month return as our covered call on AEM gold would have to go to rally more than US $110 or CDN $170 per ounce. So what is the probability that gold rises by that much over the next sixty days?

The answer can be found in the option pricing formula… specifically the delta. The answer is that there is a 22.7% chance that gold will close above US $1,397 over the next sixty days. It may well do that but personally I like the odds associated with the AEM covered call where there is better than a 50% chance the shares of AEM will close above the $66 strike by the August expiration.

Could Rates Go Lower?

Could we see lower interest rates? On the surface it seems counterintuitive with North American rates near zero and a Federal Reserve on a track to normalization. But with some industrialized economies – notably Switzerland, Germany and Japan – issuing debt with negative rates, near zero is beginning to look like the best game in town.

We are seeing major institutional investors putting money to work in Canadian and US Treasuries which is propping up bond prices and reducing yields. Not so much on the short end but in the ten to twenty year maturity spectrum which is causing the yield curve to flatten. The point is we could see lower rates despite upward intervention by the Bank of Canada and the US Federal Reserve.

The challenge is putting money to work in sectors that will benefit from lower rates. That’s easier said than done because we find ourselves in uncharted territory. We are not in an environment where lower rates are likely to stimulate demand. It has not had the desired effect in Europe or Japan and so far has been a non-event on this sides of the pond.

Based on history, we can assume lower rates will have a negative impact on the banking sector. Banks lend long and borrow short. A flat yield curve leaves no margin. This environment is particularly painful for US money center banks which continue to operate under tough government regulations.

Canadian banks are in a better position because they are playing under well-established rules, are well-capitalized, hold decent mortgage portfolios and assuming oil prices stabilize, will not have to increase loan loss reserves for exposure to the Canadian oil patch.

History suggests that highly leveraged companies benefit in a low interest rate environment. Assuming they can borrow at prime. Much depends on whether they are operating in a sector with decent prospects. For example, oil companies have significant leverage which is highly beneficial when oil is above US $70 per barrel. Not so much at US $50 per barrel.

Airlines also carry a lot of leverage but unlike oil companies, are in a period of healthy passenger volumes and solid profit margins. Management can anticipate reduced carrying charges when financing fleet upgrades. Low oil prices coupled with more efficient engines in an upgraded fleet help manage expenses. Bottom line over the short to medium term everything seems to be going right for this volatile sector. Longer term be mindful of higher fuel prices and increased wage demands from unionized workers.

Historically low interest rates should be good for commodities. Notably gold which has a cost of carry attached to its price. But this time the link between interest rates and commodities has been mixed. And that’s the rub!

We are experiencing a period where there is no historical precedence which means we are making decisions in a vacuum. In such an environment you have to work with what we know to be true.

To that point the cost of money has a defined impact on option premiums. More specifically the difference between the risk free rate of interest and dividends – if any – paid by the underlying security impacts the value of calls relative to puts. Admittedly the cost of capital is not as important as volatility, but that can be an advantage if we are able to collect better than average premiums when volatility expands, and can do so in an environment where the cost of money is declining.

You may discover that selling low risk covered or cash secured options is the best strategy in an unprecedented environment.

MX June Option Workshops

Equivalent Option Positions

In the past couple of months, I authored three commentaries talking about covered straddles. There was the blog on Bombardier (April 18, 2016), another on energy stocks (May 3, 2016) and finally one on gold stocks (May 9, 2016). I call it the double up double down approach to investing.

Without re-hashing the specifics of the previous discussions I wanted to take a fresh look at the structure of the strategy. While not as appealing – editorially speaking - as the double up double down vernacular, selling two puts instead of one covered straddle results in the same risk reward characteristics. Selling short two puts is more efficient; one trade ticket, one commission, easier exit strategy all with the same result.

The point is all option positions have equivalent alternatives. Any strategy, no matter how complex, can be set up using one or two possibilities. The foundation of Equivalent Option Positions is the Equivalent Shares Position (ESP) discussed in last weeks’ blog.

To make the point, let’s return to our hypothetical XYZ stock framed with the following assumptions;

XYZ is trading at $50 per share and does not pay a dividend
XYZ six month 50 call is trading at $3.00 with a delta of 0.60
XYZ six month 55 call is trading at $1.00 with a delta of 0.40
XYZ six month 50 put is trading at $3.00 with a delta of 0.60
XYZ six month 45 put is trading at $1.00 with a delta of 0.40
The short term interest rate for a credit balance is effectively zero

If we wanted to execute an at-the-money covered call, we would buy XYZ and write say the XYZ six month 50 calls at $3.00. If XYZ is above $50 in six months the shares will be called away. The six month return if called is 6% ($50 purchase price + $3.00 per share premium divided by $50 purchase price – 1 = 6% return).

If instead we sell a cash secured at-the-money put option, we would also receive $3.00 per share. We would earn no interest on the account balance that is being used to support the short put. If the stock closes above $50 per share the put will expire worthless and the six-month return would be 6%.

In effect the two positions have the same risk reward characteristics. The maximum risk with both positions occurs if XYZ decline to zero. The best case return on both positions is the same at any price point above $50 per share.

Same with the covered straddle. We buy XYZ and write the six-month 50 calls at $3.00 and the six-month 50 puts at $3.00 per share. In this case we also have to set aside sufficient capital to secure the short put. Total premium is $6.00 per share which results in a total return on invested capital (note invested capital is $10,000, $5,000 to buy 100 shares of XYZ that covers the call and $5,000 in cash to secure the short put) is 6%. Obviously these are approximations. In point of fact, you could hold other securities in your account to cover the margin requirements, for the short put which was the assumption I was making when I talked about the covered straddles in the previous blogs. But, from the perspective of risk and return metrics these figures are applicable.

Traders could implement an equivalent covered straddle position by doing the following’; write two cash secured puts or execute two covered calls against a 200 share position in XYZ. Each position assumes that no margin is being used.

If we break down each position into its component parts it becomes apparent all three approaches provide equivalent results. The covered straddle is just a covered call and a cash-secured put. The covered call position is equivalent to a naked put position, and the naked put in the covered combination is the same as the naked put in our earlier example.

Any option strategy that can be structured using calls, can also be structured using puts. It is the interchangeability of option strategies that allows professional floor traders to take offsetting positions when providing liquidity to the market.

With that in mind, the accompanying table looks at a partial list of equivalent positions.

Long stock is equivalent to Long call + short put
Buy call is equivalent to Long stock + long put
Buy put is equivalent to Short stock + long call
Buy stock + sell call (covered call) is equivalent to
Sell call is equivalent to Short stock + short put
Buy 100 shares sell two calls (ratio write) is equivalent to Short 100 shares + sell 2 puts
Buy 100 shares + sell call + sell put is equivalent to Short 2 puts, long 2 covered calls

Moving Beyond the Basics with the Covered-Call Strategy

Bull Call and Bear Put Spreads: Pairing Option Strategies with Forecasts

The Covered Strangle is both an Income and Investment Strategy

Betting on A Volatile Finish to the Year

There has been no shortage of volatility in the Canadian stock markets over that last year. It was April of 2015 that saw the S&P/TSX60 top at the 905.00 level and usher in a 9-month bear market decline that wiped out 25% of the value of the TSX down to the 680.00 level in January 2016.  Over the last 4 months, the S&P/TSX60 has materially bounced back, currently trading back to the 820.00 level.

Many are now asking - Is the bear market over?

One can easily write a 1000-word article on the topic and only scratch the surface of the debate, but we will summarize it as follows:

  1. Do you believe the global growth story has turned positive?
  2. Do you believe that commodity prices have broadly turned bullish?
  3. Do you believe that the core issues in the Canadian economy have been resolved?

My question - why corner yourself to having to pick an opinion when you can implement an options strategy that can profit, regardless of the direction.  Let’s discuss how:

The Long Strangle Strategy

The strategy involves you anticipating that there is a big move coming in the market, but you are uncertain as to if it will be higher or lower.  It involves buying a call option and simultaneously buying a put option.  These options often have the same expiration and typically are both “out-of-the-money”.  In addition, because you are the buyer of both options, it is ideal for the implied volatility of the market to be at the lower end of its range.  This minimizes the Vega risk, and can have sudden spikes in volatility work in your favor.

Example of a Long Strangle using the XIU

The XIU is the iShares S&P/TSX60 Index ETF, which strives to replicate the performance of the Canadian market.

  • April 2015, the XIU traded to a high of $22.78
  • January 2016, the XIU traded to a low of $17.07
  • Our investor believes that by the end of the year the market will either make an all time new high, or reverse and break down to $17.00 or lower

The option strategy:

  • The XIU closed on May 31st at $20.72
  • Buy the December $21.50 call option – asking $0.30
  • Buy the December $19.00 put option – asking $0.52

Investor outlays $0.82 net cost for the combination which equates to $82.00 for every 100 share combination the investor wishes to control.

The added bonus is that the current level on the VIXC (S&P/TSX60 Volatility Index) of 13.71 is near the bottom of its range (note the blue chart below).  This suggests that if a sharp move in the market spikes volatility, both the call and put option would increase further in value, enhancing the returns.   As an example, if the VIXC just returned to the 30 level it traded at in February, the options could double in price solely from the Vega effect.

In summary, in periods where there is directional uncertainty, but the potential for big moves, the strangle is a valuable strategy available to traders.