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.
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.
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:
- I own my Magna shares in my RRSP, which immediately removes the variable of tax considerations.
- 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.
- 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.
- 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?
- 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.
- If the stock continues to advance and I do buy them back, I will take ownership before the next August 28th dividend.
- 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.
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
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
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
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.
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?
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.
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.
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.
- Posted by Patrick Ceresna on April 30, 2014 filed in Options Market, Trading Strategies
- Comment now »
The Canadian energy sector began 2014 with a bullish advance that has seen many of the stocks rise 20+%. Clearly there is a bullish buzz unlocking the low valuations we have seen on these stocks over the last few years. The big question…is this sustainable?
The Bull Argument:
1. Attractive valuations
2. Attractive dividends on positive cash flows
3. Geopolitically safe at a time when Russia is creating increasing uncertainty on long-term supply
The Bear Arguments:
1. Abundant new supply of energy in America
2. Substantial discount of bitument oil over West Texas Crude
3. Continued issues of transportation and delays in the Keystone Pipeline
4. The price rise in the energy stocks is not being accompanied by a material advance in crude oil prices that remain around $100.00 a barrel
Whether you are bullish on the energy names or not, you must consider the risk and reward of monetizing unrealized gains vs. potential further gains and dividends that could be made from continuing to hold. This is where options can help define certainties that normal investors could never have. Let’s look at a scenario of an investor that owns Canadian Natural Resources.
The investor owns 1000 shares of Canadian Natural Resources (TSX:CNQ). They were originally purchased back in October 2012 at $30.00 a share or $30,000.00 total investment. Since the purchase, the investor has received 6 quarterly dividends that have amounted to $905.00 in dividend income. For over a year, the investment resembled dead money as CNQ did not initially participate in the material bull market south of the border. But our investor has now been well rewarded for his/her patience as the last 6 months have brought about a very robust bull advance that has share prices exceed $45.00, or over 50% higher from the original $30.00 average cost base.
Any investor that has been around the block knows that all stocks go through peak and trough cycles. If given enough time, investors will begin a healthy profit taking cycle. So let’s debate the investors situation. First off, there is the potential that CNQ can continue to advance higher and exceed $50.00 per share. At the same time, the stock can easily give back 50% of the advance, something the stock demonstrated in November 2012, June 2013 and August 2013. These profit taking pull-backs are not necessarily fundamentally driven, but rather the natural course of price moment in the process of investors buying and selling. If the stock was to begin one of these profit taking cycles, it is not out of line for there to be a $5-$10 pull-back in the stock, which could result in a $5,000-$10,000 swing in market value of investment.
So, if the investor chooses to remain invested, they will continue to benefit from a quarterly dividend and not have to worry about the tax considerations of the sale of the shares. In addition, there is the potential of further gains. Alternatively, the investors that take the important step of converting paper profits to real profits remove the psychological stress that comes with watching paper profits disappear in an inevitable profit taking cycle.
So what if the investor redefines that trade by collaring the stock? In this case, the investor wishes to secure the stock’s range for the remainder of the year. At the time of this article, CNQ is at $44.60. The investor buys a January 2015 $44.00 put option for $3.00 per share, or a $3,000.00 cost. This put option guarantees that the investor can, under any circumstances, sell the shares at $44.00 over the remainder of the year. To offset that cost, the investor sells a January 2015 $50.00 covered call for $1.10, or a $1,100.00 income.
So what has the investor accomplished?
- The investor does not need to initially worry about any tax considerations for selling the shares
- The investor continues to collect the dividends for the remainder of the year
- The investor is guaranteed $14.00 or $14,000.00 in capital gains profits if the stock reverses
- The investor continues to have the upside to $50.00 per share (further $5,000+) and can roll up the strike if the investor feels there is room for even further gains
- All of this is achieved for a fixed upfront net cost of $1,900.00.
This may not appeal to all investors, but for investors that prefer less stress, this options strategy (at a cost) can help create those certainties. Certainties that the stock market alone cannot give.
There is an old adage in the investment industry; “sell in May and go away ‘til labor day.” Not everyone agrees… Warren Buffett for example! Still, enough investors believe in the concept, and when you think about it there is rationale underpinning the theory. Summer holidays can limit liquidity and often there is little news to encourage significant moves.
Of course, this time could be very different with political issues potentially altering the landscape, unrest in Ukraine being front and center! With the Russian military amassing along the Ukraine border and US sanctions not likely to weigh on any decision Putin may make, this situation could escalate quickly. In a worst case scenario, all bets are off.
Ukraine’s GDP ranks 37th in the world, according to the World Bank, and is about 1% of US GDP. In other words, not significant in terms of world output. The real concern is that military action in the Ukraine spills over into Europe. That’s not a major concern, but with instantaneous reporting it could spook the financial markets. Certainly, if we see any major move in North American markets I would expect it to be to the downside.
With that in mind, there are a couple of things to think about. Assuming you want to stay invested through the summer months, you might think about hedging your bets with puts. Index put options are cheap based on the implied volatility as seen in the VIXC (i.e. the Canadian Volatility Index). The iShares S&P TSX 60 Index Fund (Symbol: XIU, Friday’s close $20.87) Sept 20 puts could be purchased at 35 cents.
You could also look at options on the iShares S&P 500 Index ETF (XSP, $21.46) Sept 21 puts at 70 cents. This particular ETF is hedged to the Canadian dollar, which may not be particularly helpful should US stocks tumble. In that scenario, I would not be surprised to see the US dollar rise in value, which would be hedged away in this ETF.
If you spend a little time surfing around the Montreal Exchange site you will eventually make your way to the MX Indices tab. At the top of the menu you will find a link to the VIXC, which is the S&P/TSX 60 VIX or volatility index. The VIXC reflects the 30 day implied volatility of S&P/TSX 60 front month and next month options. Implied volatility is the component of the options price that reflects expected or anticipated movement in the underlying security. If a stock or an index is expected to trade with in a predictable range, implied volatility or IV tends to remain low. However, when there is an expectation of uncertainty or an element of risk introduced to the market, IV will increase. I try to explain it like car insurance premiums. If you fall into a low risk category and have a history of safe driving, your car insurance premium is low. If you fall into a more risky category or perhaps land yourself a speeding ticket, even though you have yet to get into an accident your insurance premium will increase. This is the insurance companies way of hedging against the possibility or probability of an accident.
If we think of option premiums in a similar way, it becomes a little easier to understand why the VIXC has negative correlations to the underlying market. As the S&P/TSX 60 begins to show signs of weakness or there is a broader market concern for risk, S&P/TSX 60 options, also known as SXO options, will be priced higher to compensate the option writer for the uncertainty.
Below is a snap shot of the VIXC. Note that the S&P/TSX 60 Index is in the red and a measure of the implied volatility of SXO options is represented in blue. You should be able to see the negative correlation clearly.
It is important to realize that each stock and their associated options will have their own comparative measure of implied volatility. The VIXC provides us with a good indication of market conditions in general, however we still must pay attention to the relationship between the historical volatility and implied volatility of individual stocks. This is due to the unique risks associated with certain companies that are not necessarily reflected in a market index.
With that in mind, we can use the VIXC to help us determine which strategies might be more effective based on the market conditions. For example, when the VIXC is in the low area of the range between 8.5 and 10, this represents a period of overall low implied volatility and options may be considered undervalued or fairly priced. This is a good time to be an option buyer from a pricing perspective. Keep in mind that this doesn’t mean you will necessarily be correct about your outlook, just that you have a reduced risk of loss due to a contraction of implied volatility. In addition, a closer look at the chart suggests that when the VIXC is at its lowest and the index is at it’s highest a market pull back may soon follow. I look at this as a sign of complacency in the market and a good time to consider buying protective puts or locking in some profits ahead of a potential sell off.
When the VIXC is in the high area of the range between 14 and 16, this suggests implied volatility is high and options may be considered expensive. During this period, option writers can collect a higher premium due to market uncertainty. In addition, traders who are considering taking a directional stance using options may consider using debit spreads as a way to offset the increased implied volatility.
Currently, the VIXC sits in the middle. This suggests option premiums are pricing in some risk and investors should consider this when looking to take a bullish stance on the market. Protective puts, collars and spreads are good considerations in this market environment. Close attention should be paid to the implied vs. historic volatility of individual stocks to ensure that the correct strategy is being used based on the observations.