The Canadian Bear Market Roars!

I find a sense of irony that investors need to be losing 20% or more on their equity investments before the economic experts feel they can officially conclude that it is a bear market.  It makes it almost meaningless to react to the news as often the worst part of the portfolio damage has already occurred.  None the less, we find ourselves in a situation that is a double whammy for Canadian investors, as they are being pummeled by the currency and the stock market simultaneously.    This makes the situation here financially far worse than places like Japan where their 2013-14 currency plight was accompanied by an equity rally, lessening the financial impact on the average Japanese investor.


The brutal reality is that over the last 18 months, any Canadian investor invested in Canadian Dollars owning a Canadian equity fund is down over 20% on their investment and down a further 30% in the decline in the purchasing value of the currency.  A hard pill to swallow!

Bear Market Options for Clients

The most common response given to clients is the typical cliché of “don’t panic”, focus on the “long-term plan”.  While I fully understand that based on portfolio management theory, a diversified portfolio should be able to weather the storm; the increasing problem is that asset classes that in normal conditions behave uncorrelated suddenly correlate when volatility and fear are introduced to the market.

This is where I feel there is value applying a hedging strategy to reduce an investor’s exposure.

Implementing a Collar to Hedge Risk

While this strategy can be implemented on broader ETFs, we will illustrate the strategy on an individual stock.  Let’s discuss a scenario where an investor has owned the shares of Alimentation Couche-Tard.  The investor purchased 1000 shares of the convenience store operator back in 2014 at $30.00 a share and has been happy about the rise in the stock price to its current $60.24 level.  The investor is torn as to how to proceed.

  • The investor likes the stock but is concerned that the stock may reverse lower and fall victim to the broader bear market.
  • The key consideration is that if they sell the shares, they will incur over $30,000 in capital gains.

The investor decides to implement an options strategy called a “collar” to protect their investment. This involves selling a covered call on the stock above and using the proceeds toward buying a protective put to hedge the downside risk. Here is the scenario:

  • Alimentation Couche-Tard (ATD.B) is trading at $60.24 (February 2, 2016)
  • The May $66.00 covered call is bidding $1.20
  • The May $58.00 put option is asking $2.50

The investor sells 10 of the May $66.00 covered calls (1000 shares) and receives $1,200.00 in premium income.  At the same time, the investor buys 10 of the May $58.00 put options (1000 shares) for $2,500.00.  This was at a net cost of $1,300.00 ($2,500.00-$1,200.00).

What has the investor created?

The investor has created a scenario where between now and the May 20th expiration, they have the obligation to have to potentially sell the shares at $66.00, or about 10% higher than where it is trading.  At the same time, the investor has guaranteed that if the stock was to decline, they are able to sell it at $58.00, no matter how low it goes.  During this time, the investor has 4 months to see how the stock behaves before making that critical decision to realize the tax liability of selling. At least in my eyes, this represents a solid alternative to the rushed decision to sell or hold.

Markets Down… Volatility Up!

Worst start for equity markets since 2008! With more to come if you believe the prevailing view on Bay and Wall Street. Simply not enough “blood in the streets” according to the bears. Which itself is an interesting take since no one can provide clarity as to why markets had such a terrible start to the year. Aside from the obvious view that investor sentiment has been altered.

As for fundamentals we could look to slowing growth in China which over the past year has resulted in more than US $1.3 trillion of capital outflows. Some of which I suspect, has found its way into Vancouver and Toronto real estate.

The hitch with the “slow-growth-in-China” theory is that nothing is new. This is a story about an economy transitioning from its reliance on exports to one supported by domestic consumption. Such transitions create dislocations which can cause global shockwaves. However the long term strategy is rational and most economists recognize the playbook. For China to get there it needs a resilient middle class supported by a strong housing market and robust capital markets governed by well thought out rules. None of which currently exist. Still, longer term, it is the right move that will simply take time.

The oil question is more worrisome. Middle East competition for market share has removed any notion that economics of supply and demand have a role to play in this march to the abyss. The Middle East is engaged in one-upmanship of the worst kind intent on pounding ones’ enemies into submission. The oil sledgehammer being the weapon of choice.

Surprisingly Russia has taken the lead in an attempt to persuade OPEC – read Saudi Arabia - to step back from the abyss. And those efforts may work if the Saudi’s believe that curtailing production would assuage Russia to be less enthusiastic about their relationship with Iran. Time will tell!

In the meantime Canada and US oil producers are trying to survive while the Middle East clarifies its pecking order. With smaller oil producers going out of business there is real fear that it could gravely impact the North American junk bond market. To the point that some of the more vocal bears have been comparing the current situation to the one leading up to the financial crisis. I think that’s a stretch but it does explain the performance of financial stocks which have been tracking the energy sector since the beginning of the year.

What seems clear is that we are in a period of Mutually Assured Disinflation (MAD) caused in no small part by a strong US dollar and central banks efforts at quantitative easing (i.e. Japan and Europe). And despite the sharp rally on Friday I believe we will likely remain in a trading range through the first half of 2016. A thesis supported by the bond market that continues to rally in what looks like a flight to quality.

With that in mind investors would be well served to evaluate the potential downside and where possible, hedge with options when the market spikes as we witnessed on Friday. Especially as premiums remain well above their 200 day moving average.

Personally I am taking advantage of rallies to sell overpriced calls to take in cash flow through the first half of the year. Of course this should not be a static position. It may require you to to roll the covered calls up or down depending on market conditions. Should markets stabilize option premiums will contract and there may be an opportunity to close some positions at a profit. Think about it this way; you are using the covered call strategy as a hedge and not as a tool to set a target price to sell the shares.

Other hedges to consider include buying puts for insurance purposes. The problem with this strategy is that you are paying up for insurance because of the higher premiums. The alternative is to employ put spreads where you hedge to a specific target in the market. Using a spread takes volatility off the table because you are buying and selling expensive options.

Suppose for example, you believe the iShares S&P TSX index Fund (symbol XIU, Friday’s close: $18.92) could decline 10% from current levels. That would put the downside for XIU to say $17.00. You might consider buying the XIU June 19 puts while simultaneously selling the XIU June 17 puts for a debit of 65 cents.

Using the June options is in keeping with the second half story thesis. Think of the XIU bear put spread as your insurance policy with a potential profit of $1.35 versus a cost of 65 cents. If the position ends up losing money your portfolio should have increased in value by an amount that would minimize the cost of the insurance.

Belated Resolutions for the New Year

I don’t usually make New Years’ resolution because I rarely keep them. But in my world there are times where you need to reassess how to best deal with the operational aspects of trading options. Unfortunately these reassessments are usually the result of costly mistakes.

Resolution 1: Avoid expiration nightmares!

Always remember that options do not expire on the last day of trading. They exist as a contract until the Saturday following the last day of trading. Take as an example the December 2015 expiration of options on Canadian National Railway. On behalf of clients I had sold more than 60 CNR December 78 calls which were covered by the underlying shares.

On Friday December 18th, which was the last day of trading for the CNR December options, the stock closed at $77.85. That’s an ideal situation! The shares closed just below the strike price. The options expire worthless. Clients keep the stock and for good measure, December 18th was my birthday. The world just seemed…. right!

I got another present Monday morning as CNR shares rallied at the open and remained well above $78 per share throughout the day. I decided to sell the 6000 shares (these were the shares which were covering the now expired short option position) during the day and open a new covered call position with a different underlying stock.

On Tuesday morning our inbox had a notice from our custodian that we were short 2000 shares of CNR. Apparently there was a forced exercise of 20 CNR December 78 calls on Saturday December 19th. So the sale of CNR shares occurred in accounts that no longer held the shares.

We had to enter a buy order for the 2000 short CNR shares on Tuesday morning which was positioned through our error account so as to ensure that no client was harmed.

There are two lessons from this. Just because the underlying stock closes out of the money on the last day of trading does not ensure that short options will actually expire worthless. The holder of the options can force an assignment no matter what the price for the underlying shares at the close of trading on Friday. The second lesson is to ensure that you review all option assignments on the Monday morning following expiration before making any changes to a portfolio.

Resolution 2: Legging into Spreads

Spreads are a common option strategy. They help reduce risk, provide excellent risk reward characteristics and can be used to fine tune one’s outlook for the underlying shares.

The strategy is straightforward; you buy a call or put and sell another call or put with a different strike price and / or expiration date on the same underlying stock.

For example XYZ is trading at $55 per share. You are bullish and decide to buy the XYZ July 55 call at say $3.00 and sell an XYZ July 60 call at $1.00 for a net debit of $2.00 per share. The problem is not the strategy but rather how the strategy is executed.

Many investors attempt to leg into the spread taking one side – either buying the 55 calls or selling the 60 calls – and then “legging” into the other side once the first trade has been executed. The challenge is that the underlying shares can move dramatically when trying to time the remaining side of the trade.

The resolution is simple; never leg into spreads. Always enter a spread as a net debit or net credit. With the XYZ example the order would be entered as a spread with a $2.00 per share net debit. Under this scenario you are indifferent as to the price paid or received for the position only that the cost is no greater than the net debit or credit stipulated in the order.

Resolution 3: Know the personality of your client

Each of us have unique ways to deal with the stresses associated with investing. So much so that one of the fastest growing areas of investment literature is behavior finance that examines how investors react to specific stresses.

One of the more prominent concepts is “Prospect Theory” which looks at how we deal with risk. Studies show that investors react more intensely to a loss then they do to upside underperformance. Effectively the pain you feel from a loss is significantly greater than the gratification you feel when booking a profit. By a factor of 2 to 1 if you believe the surveys.

Applying that theory to options comes down to how you apply specific strategies. For example, using the XYZ spread example, there are two ways to take a bullish position on the underlying shares. You could employ the aforementioned bull call spread where the risk is the loss of the $2.00 per share debit versus the potential of earning $5.00 per share should the stock rally above $60.

However you could also execute a bull spread using puts. In the case of XYZ you would sell the XYZ July 60 put at $6.00 per share and buy the XYZ July 55 put for $3.00. Rather than an initial net debit in the bull call spread you receive a credit of $3.00 per share which is also your maximum profit should the stock be trading above $60 at the July expiration.

In this simplistic example the maximum potential profit from the bull call or bull put spread are equal. Although in reality, assuming the same strike prices, the maximum profit for the bull call debit spread would be ever so slightly higher than the maximum potential return from the bull put spread. That simply reflects the cost of money which at the moment is negligible.

The aforementioned caveat aside, the right option strategy comes down to how you emotionally rank the debit versus credit trade. Are you more comfortable paying up to acquire the “right” to buy shares or do you feel better when you take in the maximum potential profit at the outset while assuming an obligation to buy the underlying shares? While there is no right approach it is important to understand your investment personality. It simply makes you a better investor.

Resolution 4: Limit orders only

A good rule of thumb is to only use limit orders when entering a new option position. Especially if you are dealing with an illiquid market on a specific security. This resolution also has roots in prospect theory. Which is to say the pain you will feel from missing an opportunity as a result of entering a limit order is usually less than the pain you feel from acquiring a bad position because you entered a market order.

Survival of the Fittest in the Oil Patch

I was screening some of the headlines in the Globe and Mail this morning and came across an update on Suncor (TSX:SU) and its bid for Canadian Oil Sands (TSX:COS).

According to the Calgary Press, Suncor and Canadian Oil Sands have settled on a $6.6 billion deal which includes stock and debt. Interestingly enough, Suncor increased its bid conceding that its previous one was too low.

Suncor closed on Friday, January 15th at $31.22, well off of its $40.00 highs of the year.  Of course the slide in oil stocks is not new considering the downward spiral of the commodity throughout 2015, falling below $28.00 per barrel just last week.

Regardless of why oil continues to weaken, whether it’s USD strength or supply and demand considerations, the financial stability of many energy companies are being tested and this is going to prove to be an interesting opportunity as things unfold.

The recent play for Canadian Oil Sands by Suncor is just one example.  As certain companies struggle, the stronger players will step up and take advantage in a Darwinistic, survival of the fittest environment.

What will emerge is a stronger, more efficient collection of companies poised to benefit when oil finally finds a bottom.

If the recent move by Suncor (TSX:SU) is an indication, perhaps there’s an opportunity here to take advantage of what may be one of the stronger players.  Admittedly, there is no indication technically that the share price is poised to turn around. However, the move to increase the bid for TSX:COS suggests that management feels they are positioned to weather the current environment and is subscribing to the old Wall Street adage that when there’s blood in the streets it’s time to buy.

I will not be so bold as to predict when things may turn around but what I do believe is that this will not be the last we see as far as mergers and acquisitions are concerned in the energy sector.

That said, if we assume that Suncor will be one of the companies left standing, now might be an interesting time to consider taking a position in the Canadian energy giant.

The risk of course is that we have not yet seen the end of the selling. While this is a valid concern, there can be much to gain by having the nerve to buy when others are afraid.

This is where the option market shines.  An investor wishing to secure a position in the stock but concerned about the risk can simply use a call option strategy to achieve their objectives.  I know many readers look for the opportunity to learn about some advanced combination, however I am of the belief that it’s better to keep things simple when ever possible.

As I mentioned, trying to predict when a turn around might occur is a bit of a fools game.  As such, we need to allow for as much time as possible for our expectations to play out.  This is where a long term call option becomes a great stock replacement strategy.

The last price of the January 2018, $30.00 strike call option on TO:SU was $5.90.  With the shares at $31.22 on Friday January 15th, 2016, the option premium had $1.22 intrinsic value and $4.68 time value.  Since we can’t lose more than the entire premium, $5.90 represents the maximum risk on the investment for the next 2 years.  Admittedly, that works out to be about 18% which may be a little high.  Keep in mind that we can close the position at any time to cut losses and lock in profits. for example, if we saw a re test of $40.00 over the next 2 years, the $30.00 strike call would be worth at minimum its intrinsic value of $10.00.

While I suggested that we would want to keep this simple, I do believe it is worth looking at strategies that might help reduce our overall cost basis.  With this in mind, we could consider making this a Calendar Spread.

While holding the long term call, we could sell short term, out of the money calls to generate monthly cash flow.  The objective is to lower our cost which in turn lowers the over all risk and break even point on the position.

For example, While holding the January 2018, 30 strike call, we can sell a February $34.00 strike call and collect $0.50.  This lowers our cost by about 8%.  Our strategy will be to do this on a regular basis, adjusting the written strike as the shares fluctuate. The ideal scenario is that we are able to do this consistently, collecting our monthly premium while benefiting from a slow and steady appreciation in share price.

Of course there’s always a trade off when creating option combinations and this strategy is no different.  The challenge is if the shares jump quickly and significantly before our written contract expires. If, on expiration, the stock is trading above the written strike, we would be assigned to deliver the shares.  If we use the above strike prices and premiums as an example, the net cost of the spread would be $5.40.  We have the right to own the shares at $30.00 and an obligation to deliver them at $34.00.  If we are assigned to deliver the shares at $34.00, We can exercise our right to buy the shares at $30.00.   Technically our profit would be $4.00, representing the difference between the strikes. However, because the position cost us $5.40, the early exercise of our long call to cover the assignment will likely end up resulting in a small loss.

The alternative is that we roll the written option by purchasing it back to close the position before expiration.  We would then subsequently write a new call at higher strike and further out expiration month.  While this may cost us initially, we maintain the upside potential on the longer term call.

For the investor looking to take a longer term outlook on a company and limit the amount of capital that is tied up, the call option is a great stock replacement strategy.  The investor can lock in profits or cut losses at any time if the outlook changes to avoid losing the entire premium. An investor who is more pro-active can write short term calls to off set the cost of the longer term contract.  While this is well worth considering, they should be prepared to make adjustments along the way should the stock take off in a hurry.

The Risks of Prolonged Commodity Weakness

The Bank of Canada released its semi-annual Financial Systems Review on December 2015. Click to download the Report.    While the report was comprehensive in looking at Global Macro Risks, we wanted to focus on their comments on the global commodity markets.

Here is an excerpt from the report (p.27):

Risk 4: Prolonged Weakness in Commodity Prices

“There is a risk that strong global supply continues to exceed demand, leading to prolonged weakness in commodity prices at current or somewhat lower levels, with adverse implications for the Canadian financial system. This risk is rated as “moderate.” The probability of the risk occurring is medium, and the severity of the impact on the Canadian financial system if it were to materialize is assessed as relatively low.”

While I agree that the risk of prolonged weakness in commodity prices has a destabilizing effect on the Canadian financial system is low, its impact would be far more reaching to Canadian investors that have been watching their beloved resource stocks suffer greatly in what can now clearly be labelled as the worst commodity bear market this century.

Normally when commodity prices decline in this magnitude (think 2008), the natural instinct for investors is to buy the dip or dollar cost average. The problem this time around is that if Stephen Poloz and the BoC’s risks come to fruition, investors may find themselves too early and risk prolonged inactivity.

So what can an investor do if they find themselves down considerably on a number of these resource names?  One can consider selling cash covered puts at lower prices as a way to reduce your cost base and potentially average down at more favourable prices.

Let’s use an example using Canadian Natural Resources (TSX:CNQ).

  • Investor originally purchased 300 shares at $40.00 or $12,000
  • The stock had a high of $49.57 in June 2014 and a low of $25.01 in August 2015
  • The investor still likes the company and would like to dollar cost average his position, but fears that the stock may remained challenged for at least 6 months or a year.
  • The stock is trading at $29.67 at the time of writing

Rather than purchasing the shares at the prevailing ask or placing a limit order at a lower price, the investor chooses to sell a cash covered put.

The investor sells 5 contracts of the May $25 put for $1.30 or $650.00 gross.  This obligates them to potentially have to buy 500 shares at $25.00 ($12,500) over the next 6 months.  Having collected a fixed $1.30 cash flow income, if the investor is assigned they would be buying the additional shares at an average cost base of $23.70.

Let’s review the possible outcomes for our investor at the May expiration:

Scenario 1: CNQ is trading at, or above $25.00.  In this scenario the investor simply continues to own the original 300 shares and has made an income of $650 or 5.41% from the puts profitably expiring.

Scenario 2: CNQ is trading below $25.00. In this scenario the investor is assigned on the put option and must honour their obligation to buy 500 shares at the $25.00 strike price. Considering the investor still owns the 300 shares at $40.00 and has made $1.30 a share in income, the investor now has a total of 800 shares at the new adjusted cost base of $31.44.

Any investor that accepts the risk of prolonged weakness in commodities can consider using put options as one of the alternative methods to average down at more favourable prices.

Royal Bank Post Earnings Play

Royal Bank (TSE:RY) announced earnings December 2nd and surprised the street with a resounding beat of the estimates. According to Reuters Canada, the banking giant reported an 11% rise in fourth quarter profit ” …driven by at its personal, commercial banking and capital market businesses” (Thomson Reuters Dec 2)

While they did cite a concern for the oil dependent regions of the country, the market liked what it heard as shares jumped at market open and are up just over 1% from yesterdays open.

As a student of technical analysis, a study of the price action leading into the announcement indicated that traders and investors were uncertain about what to expect.

If we take a look at a daily chart, a sideways triangle can be observed forming, beginning the first week of November. This pattern is identified by lower highs and higher lows and often forms ahead of important announcements. It is often referred to as a coil.  The consideration is that the price action becomes tighter as the event approaches and, much like a coil or spring, there is a build up of “energy” and anticipation that tends to resolve with a volatile move.  The challenge is determining which direction.

Daily, December 2, 2015

From an option traders perspective, this kind of pattern represents an opportunity to implement a Straddle or a Strangle. Since there is no short term directional bias, and a significant build up of “energy” and anticipation, there is the potential for a significant move in either direction.  As a note of caution, this build up of energy and anticipation also comes with an increase in implied volatility, making options more expensive ahead of the announcement.  The trader runs the risk of a volatility crash once the numbers have been released.

From an investor stand point, this may be an opportunity to get long the stock.  To keep it easy, I have added a 200 bar exponential moving average to the chart below.  The last 3 days price action, combined with the positive earnings have resulted in some commitment above the longer term average.  This 200 bar EMA line can now be used as a support level supporting a bullish up trend.  As long as the share price remains above, the stock can be considered bullish.

Daily, December 2, 2015

For the investor who is still concerned about the bigger picture, a stock replacement strategy with a limited risk would be worth considering.  The January 2017, 76 strike call is asking $5.75. This represents a maximum risk of $5.75 per share or 7% on the present value of the stock if the shares drop. This is also a compelling idea from a capital leveraging perspective.  The investor who purchases 100 shares will put up approximately $7700.00 while the purchase of the long term option requires only $575.00.

The trade off is that if the shares are at or below $76.00 on expiration, the option buyer loses the entire premium while the share holder may continue to hold the stock and collect dividends.  That said, the option trader can implement a Calendar Spread strategy outside of his or her registered accounts.  The rationale would be to sell out-of the-money calls monthly against the longer dated option contract.  This will bring in consistent cash flow and lower the cost basis of the position.

For example, Once the January 2017,  76 call has been purchased, a January 2016 80 strike call may be written.  The current bid is $0.45.  This represents almost 8% of the purchase price of the 2017 call.  By selling monthly, out-of the-money options, the investor can make a sizable dent in their cost basis, break-even point and risk exposure.

While a traditional investor only has 1 way to capitalize on this recent move,  an investor who has integrated options into their game plan as a considerable number of alternative strategies to choose from.

Will Gold Miners Glitter Again?

This week ushers in a wave of 3rd quarter earnings for many of the large cap gold stocks in Canada.  We reference the term large cap loosely as the gold bear market of the last 4 years has wiped out the market capitalization of many gold miner darlings. In some cases 75% or more from their peak values.  During that bloodletting, the damage was not just financial; in fact the real damage was psychological.  Today, even the idea of buying a gold stock is immediately regarded with disdain, considered highly speculative and very much considered a losing proposition.

So why care or bother to pay attention?

Often the perspective of many investors is that the biggest profit opportunity is when a sector goes from “being bad to good”. Alternatively, over my many years of experience I have often found that there are opportunities for greatest returns when conditions in a sector have moved from being “very bad” to just being “less bad”.

So going into the earnings I will be looking for a few things:

  1. U.S. Dollar has not hurt gold - The U.S. Dollar rally has actually added a very interesting twist.  In its natural correlation, gold prices should have considerably weakened during the dollar bull advance, instead, gold has stayed rather stable.  In fact today’s gold price of $1180.00 is just $20.00 lower than its price in January of 2014 starting price near $1200.00.  This has seen gold prices in Canadian dollars soar above $1500.00 an ounce, which is a 2 year high.  Since much of the world’s gold production is not in America, the rising U.S. dollar is actually helping profitability.
  2. Production Costs – The miners have been diligently executing deep cost cuts.  Driven by that rising U.S. dollar, cost cutting has been accelerated by the decline in costs in both energy and consumables.
  3. Negative Analyst Sentiment – Most analysts remain very cautious as they do not want to stick their necks out on the chopping block.  Many remain focused on the ability of the companies to generate free cash flow which impacts the company’s ability to pay dividends or repay debt.

While the analysts are factually correct, I want to emphasize my starting point, often the greatest returns are when a sector goes from being “very bad” to being “less bad”.  With a broad acceptance that the stock market is forward looking 6 months to a year, by the time the companies are actually reporting meaningful free cash flow, it is likely they may already be trading at much higher prices.

There are two schools of thought.  One believes that gold will cease to have any meaningful value in our society and that many gold miners will cease to exist. The other believes that through history, all markets go through extensive bull and bear market phases and if you purchased shares at compelling prices at the end of bear markets, it represented a generational opportunity.

Which one do you believe?

If you are in the camp that all bear markets end and create opportunity, then this may represent a compelling time to take a risk.  The problem with trying to catch a bottom is that even if a stock declined from $40.00 down to $10.00, the stock can still temporarily decline from $10.00 to $5.00 and still draw an investor down 50% on their investment.  This is where speculating with call options represent a true asymmetric proposition.

Let’s look at an example using a long-term option on Yamana Gold (TSX:YRI)

  • Yamana Gold is trading at $3.50 at the time of writing.
  • We buy a deep-in-the-money $2.50 January 2018 call option which is asking $1.80. This represents $1.00 of intrinsic value and $0.80 of time value.
  • Two years down the road, if we exercised the option, we would own the shares at an average cost base of $4.30 ($2.50 strike + $1.80 option cost).

Let’s explore the two scenarios:

Over the two years (Jan 2018), the stock returns to its 2014 peak prices in the $9.00-$10.00 range, which will value the option (purchased at $1.80) to having a value in the $6.50-$7.50 range.

Alternatively the stock proceeds to decline back to its lows near $2.00 later this year. In this case the option would still have a time value trading near $0.70-$1.00

Obviously your personal big picture bias on the prospects of gold will influence your decision. However the key observation for me is oriented around the fact we can define and contain risk with the option and have leveraged gains if in fact gold miners do recover.

2 Ways To Use a Weekly Option For Teck Resources Earnings

Teck Resources Ltd (TSE:TCK.B) is set to report earnings before the market opens on Thursday, October 22nd. This is according to the earnings calendar found on the TMX Money website.  This great little resource can be found here.

Back on August 1st, Patrick Ceresna built a case for taking advantage of buying shares of TCK.B at what appeared to be a significant discount.

He outlined the following considerations:

  • Though there has been a contraction of earnings, the company is currently still profitable
  • The company pays a nice dividend, but with a 152% payout ratio (source: yahoo finance), implies that the dividend is at risk of being reduced or cut all together
  • From its $20.58 February high, TCK.B has materially dropped, hitting a $8.77 low in July

In his article, he outlined a Covered Call strategy whereby the investor could buy the shares at their current price of $9.35 and sell a January 2018 call.  With the shares now at $8.34, this is still an interesting opportunity and I encourage you to take a look at the article if you haven’t already.

With that said, I’ll be speaking at the World Money Show on behalf of the Montreal Exchange on Saturday, October 31st.  Details and Registration HERE.  My topic is on Canadian Weekly Options. Since there are are weekly option available on TCK.B, and with earnings set to be released this Thursday, I thought it would be interesting to look at 2 ways an investors might be able to participate.

The Chart

Below is a snap shot of the weekly chart. Note the 2009 lows comparative to where the stock is trading presently.  As the old saying goes “..a stock is never to low to go lower” (Reminiscences of a Stock Operator) but, that low reflects an important long term support and the shares have recently tested and bounced

Weekly Chart


Buy the stock, Buy a put

For the investor that feels there is a possibility that TCK.B is going to move higher on earnings, shares could be purchased (as of Friday, October 16) at $8.34.  The challenge, of course, is the risk associated with poor earnings.  To hedge this, a short term put could be purchased with the specific goal of limiting and identifying the risk in holding the shares through the earnings report.

The $8.00 strike put expiring on October 23 was asking $0.33 per contract (as of Friday, October 16).  An investor who purchases the the stock at $8.34 and purchases the put for $0.33 has limited their risk to a total of $0.67 or a maximum of 8%, regardless of how bad the report is.  If the stock takes off to the upside, the break-even is the share price paid plus the put premium.  In this case $8.67.  If the stock sells off due to a bad report, the investor has until the close of trading on expiration Friday to decide whether to exercise their right to sell the stock at $8.00 or sell the put for its market value (ideally a profit) and continue to hold the shares with the expectation that the price will turn around.

Buy a Call

The purchase of a call option would offer the investor the same risk/reward profile as the previous strategy without having to put up the money to buy the shares.  If an investor felt there was going to be a jump in the shares on earnings, the call option would allow for participation with a limited and identifiable risk exposure. The $8.00 call expiring on Friday, October 23 (the day after earnings) is asking $0.70.  Th $0.70 premium represents the maximum risk to the investor if the shares drop in value.  The break-even point on expiration is $8.70. If the shares are trading beyond that, the investor profits.  The interesting thing about this approach is that the investor has two choices on the expiration date (day after the earnings).  If the stock is trading above $8.00, they can exercise their right and take possession of the shares. They would become a shareholder and subsequently benefit from any further price increase as well dividend payouts.  If a short term profit from a positive earnings report was all they were after, they could sell the call before the close on the expiration Friday and lock in the profits.  If the shares are below $8.00, the call would expire worthless and the investor would lose their premium.

In both strategies, the investor is able to take advantage of an event driven opportunity without having to pay the time premium associated with a longer dated option.  Both the protective put and the long call have 7 days of time value, versus 30 days of time value for the next expiration date available.  This allows the investor to build a strategic position around the TCK.B earnings at a reduced price.

Creating Income from Franco-Nevada

To say that the gold mining sector has underperformed over the last 3-4 years is a significant understatement.  The sentiment in the group has never been more negative as some darling gold miners have lost more than 90% of their value.   Yet, in that environment, one gold company has been able to stand strong like the Rock of Gibraltar - Franco-Nevada.

Franco-Nevada is a gold-focused royalty company.  Instead of developing and operating mines, they focus on a diversified portfolio of royalties from highly favourable properties.  This has allowed the stock to materially differentiate itself.  There unique business plan, has over the last few years been tested against some the most perilous market conditions, and the company has thrived.  This includes the stock testing all time new highs at the start of the 2015 year.

While I am not interested in cheer-leading the stock, it was solely my objective to differentiate Franco-Nevada from the overwhelmingly negative sentiment overshadowing the entire gold and silver mining sector.

While virtually flat on the year in regards to performance, the stock has experienced considerable volatility having traded as high as $74.00 and as low as $50.00.  At its current price of $58.75, the stock is sitting pretty close to the mid-point of its year range.  From my perspective, this is a perfect stock for investors seeking covered call income.  The stock has proven to be able to weather the storm and continue to deliver to investors.  At the same time, the volatility offers the potential for covered call income worthy of consideration.

In the example:

  • Investor buys 1000 shares of Franco-Nevada at $58.75 for $58,750.00.
  • Investor sells 10 April $60 strike covered calls for $5.60 or $5,600 in cash proceeds.

What has the investor accomplished?

The investor has generated a 9.53% cash flow for the obligation to potentially have to sell the stock at $60.00 over the next 6 months.  That is close to a 20% annualized premium.  While the risk of an early exercise is a possibility, the investor is likely to enhance that income return with the 1.90% dividend the company pays annually.

In addition, if the stock was to decline while the investor is holding it, the stock would need to decline below $53.15 in order for the investor to be in a loss,  when taking the premium income into consideration.

If the investor was to be exercised and the stock was sold at $60.00,the investor would have realized a 11.66% realized gain in just 6 months.

In today’s market environment, where it is hard to find any safe haven, or any sound income, a covered call on Franco-Nevada may be a respectable consideration.

Is Air Canada Stock About To Take Flight?

I was reviewing the most active options widget found on the M-X website and came across Air Canada (TSE:AC).  Unusual or increased options activity can indicate the potential for some action in the underlying stock.

My next step was to take a look at the news to see if there was any indication as to why there might be an increased interest in the shares.  Interestingly enough, CNW Group, a news wire company, published a story entitled “Air Canada Buys Back 3,185,735 Shares at a Total Cost of 36.7 Million” Read full story here. This article was picked up by the likes of Yahoo Finance, MarketWatch and several other outlets.

Below is the quote that likely moved investors to act:

“Air Canada believes that, from time to time, the market price of its Shares may not fully reflect the underlying value of its business and future prospects. In such circumstances, Air Canada may purchase for cancellation outstanding Shares, thereby benefiting all shareholders by increasing the underlying value of the remaining Shares.” Source: Isabelle Arthur of Air Canada Corporate Finance

While the number shares repurchased only represents about 3.49% of shares outstanding, this kind of corporate action can lead to greater investor confidence and a subsequent interest in owning the shares.

When a story that centers around corporate fundamentals suggests an opportunity, I always like to add credibility by comparing the technicals. Afterall, we are dealing in a world of probabilities so the more evidence supporting a directional bias, the higher the probability that there will be a follow through.

With this in mind, the below chart does offer some evidence of a bullish opportunity as indicated by my annotations:

1. Support at long term major trend line
2. Break above 200 bar moving average
3. Bullish flag forming (wait for break above upper trend line to confirm)

air canada

Given the general or systematic risk in the market these days, using a call option to take a shot at the possibility of move higher is a great strategy.  If shares of Air Canada (TSE:AC) continue higher, the investor can benefit from the increased value in the option or exercise their right to own the shares at the strike price selected…provided the stock is trading above it.  However, if Air Canada shares fall victim to broader market weakness, the loss on the call option is defined and limited to the premium paid.  Unlike the owner of the shares who assumes an unidentifiable and unlimited risk should the shares decline in value.

For example,

With the shares currently trading at $12.10, an investor could purchase a January 2016 call with a strike price of $12.00.  The Ask price for the call is $1.65.  This represents the maximum risk on the position.  The break even on the trade is reach when the shares are trading at $13.65.  This is determined by simply adding the cost of the call to the strike price.  The investors expectation should be that the shares will be trading above this level.  According to the Financial Times, the average 12 month price target of analysts polled is $18.13 See full details here. Remember, this is no guarantee, but does offer some insight.

To conclude, the most active options “widget” found on the home page is a great resource for ideas. However, you need to do your homework to ensure that the company fundamentals and further technical analysis support taking action.