A Synthetic Long Stock Strategy For Canadian Banks

Canadian bank stocks have been somewhat unfavorable this year. Concerns about the Canadian economy, the impact of low oil prices and the pressure on lending margins from lower interest rates have had many investors questioning just how much more upside can be expected.

The chart below is a snap shot of the weekly price action for ZEB.TO  which is the BMO S&P/TSX Equal Weight Banks Index ETF.  Note the significant volatility in price action from December 2014 to present.  The technical pattern that has developed is known as a sideways triangle.  This pattern forms as a result of highs getting lower as indicated by the upper trend line and lows getting higher as indicated by the lower trend line

zeb weekly

This pattern is associated with indecisiveness.  After all, an uptrend will consistently make higher highs while a down trend will consistently make lower lows. Based on a current analysis of the chart, we have seen neither higher highs nor lower lows.  This suggests that investors are just not sure what direction the banks are heading.

Now, despite positive second quarter earnings in May, we have seen the banks largely sell off for the last several weeks.  That said, if we take a look at the ZEB.TO chart on a daily time frame, we can see that prices may be starting to break higher.

Bullish Observations

  1. Break above the 200 bar moving average.  While this is not necessarily a guarantee of a continued bullish trend in banks, it does bring the price back above it’s long term trend line
  2. Bullish flag pattern that indicates a possible continuation higher

zeb daily

So how can we take advantage of this?

Let’s assume that an investor wants to lock in today’s price just in case the shares take off.  On the other hand, if the shares pull back further, they are happy to own ZEB.TO shares at a lower price.  One strategy that they can use is a variation of a synthetic long stock position using options. By definition, a synthetic long stock position involves the purchase of an at-the-money call option while selling an at-the money put option.  The credit from the written put offsets a portion of the purchased call and the risk on the positions is comparable to owning the stock itself.

My variation would have the investor purchase a slightly in-the-money call, but sell an out-of-the-money put.  The long call offers the investor an opportunity to benefit from an immediate rise in the stock and the right to purchase the shares at the strike selected, regardless of how high the shares trade.  However, to offset the cost of this option and lower the break-even point, we can sell the out-of-the-money put and collect the premium.  The reason an investor would consider selling the put at a lower strike is because they are willing to own the shares at that price if ZEB.TO sold off.

The Trade

With shares of the ZEB.TO trading currently at $22.75

BUY December 22 strike CALL - $1.30 debit
SELL December 20 strike PUT -  $0.30 credit

Net Debit = $1.00

The investor has the right to own the shares at $22.00 and has reduced the cost of the long call position to $1.00. The Break even on the upside is now $23.00.  With the shares at $22.75, the position is only $0.25 away from break even.

If the shares drop in value, the investors risk is limited to the $1.00 net cost until the shares are trading at or below $20.00.  At that point, the investor may be assigned and will take possession of the shares at $20.00.  The break even on the position would be $21.00 based on the original cost. Once the investor takes possession of the shares at $20.00, the risk is unidentified.  Bare in mind a covered call may be written or a protective put purchased at that point to help mitigate the risk.

Daily Chart
2 Year Time Frame


In Conclusion

This strategy offers the investor who wants to own the stock the best of both worlds.  If the shares take off, the  22 strike call guarantees the investor the right to own ZEB.TO at $22.00 regardless of how high the shares trade.  The investor would also have the choice to sell the call for a profit instead of buying the shares if they were satisfied with the move.

If ZEB.TO drops in value, the investor has the opportunity to own the shares almost 10% lower, but must be aware of the unidentified risk once they have taken possession of the shares.

Playing the Weak Loonie

The Canadian dollar has fallen on hard times. The Canadian dollar tends to follow West Texas Crude so it’s not surprising to see our Loonie trading close to 80 cents US. With lower Canadian interest rates and a US rate hike all but assured the Loonie may week stay in its current range for some time.

If you buy into that scenario you want to look for companies that benefit from a lower dollar. Specifically exporters like West Fraser Timber (symbol WFT, Fridays close: $68.13) which derives close to 50% of its revenue from sales to the US.

To that point, we could see a pickup in sales as the US job market strengthens which plays into WFT’s prime demographic, specifically 30 to 40 something first time home buyers. Low oil prices means more disposable income for this demographic and by extension continued easing in 30 year fixed mortgages rates.

The company made some decent gains in the first quarter but has since settled back to the point where the share price is effectively flat on the year. As such we may not see significant improvement in the share price through the remainder of the year, but on the other hand, I don’t see significant downside either.

In other words, WFT may remain in a trading range which plays into a covered call strategy or cash secured put strategy. If the Canadian dollar continues to decline and the prime home buyer demographic plays out as anticipated,  WFT could pick up steam sometime in the first quarter of 2016.

In the interim, you could buy the shares and write the January $70 calls at $4.55 per share. There is not much liquidity in these options so consider this as a six month position. If the shares are called away in January, the six month return is 9.4% excluding dividends (note the company pays a 28 cents annual dividend). If the stock remains the same, the return is 6.7% with downside break even at $63.58.

Another approach would be to sell the WFT January $68 puts at $5.25 per share. With this trade’ you are committing to buy the shares at $68 per share less the $5.25 per share premium received. The net cost should the shares be put to you is $62.75. There is good support at $60 per share but should the stock break below that level, consider closing out the short puts.

Hedging Canadian Market Risks

In full disclosure, it is my intention to be contentious in my views as I am disappointed by the lack of diverging opinions. The Canadian economy is in trouble and it is likely to get far worse than better and it is unlikely that the passage of time will fix the problem. Here are some simple truths you must consider when reading consensus perspectives.

Investor and business confidence toward the economy is one of the most important drivers. Therefore, one has to recognize that Stephen Poloz and the Bank of Canada must instill that confidence when speaking, even during dire times. Equally, the street is full of sell side analysts and economists, which invariably express a glass-half-full perspective. The bottom line is that even if they knew the truth was dire, they would not dare publicly be caught saying so. Therefore, it up to us to read the macroeconomic tea leaves to assess market conditions. So let’s review some of the key considerations.

It is more than obvious that one can turn to the collapse in oil prices as the catalyst. However, the real risks may not be the price of oil itself, but a negative economic feedback loop that could force a broader economic slowdown throughout the entire economy. If the impact of oil was to be looked at in isolation, Canada would likely be able to weather the storm, but when combined with a number of concerning economic considerations, one can see the vulnerability to a contagion effect.

The first consideration is real estate. There have been many skeptics that have been sounding the alarm bells of Canada’s expensive and overheated real estate market, but none were as alarming as when the IMF raises the red flag. The IMF concluded that the real estate in the biggest Canadian cities was the second least affordable market in the world next to Hong Kong. This is particularly concerning as much of the job growth in Canada was attributed to the energy and housing markets.

House prices could in theory be sustained and a soft landing could plausibly occur, but it would rely heavily on stability in Canadian household income and confidence. What makes the situation concerning is the lack of wage inflation and the growing levels of household debt. While the Bank of Canada has suggested that the numbers have stabilized, one still must recognize that the average Canadian household carries 163% of debt to disposable income, one of the highest debt levels in the world. When the Bank of Canada looks to stimulate an economic turn, will the consumer have the confidence and the financial capacity to borrow and spend like they have in the past?

The last consideration is that there is little to no new capital investment initiatives to drive a considerable economic difference for the remainder of this decade. In my opinion, in order to be bullish Canada, it is not just predicting commodity and real estate stability, but rather recognizing where the future growth will emerge and this is where my concerns are focused.

To summarize, you have energy and resource consolidation, an overheated real estate market, a substantial debt burden on the average Canadian and almost no new sources of future growth. With that in consideration, it is hard to see how the Canadian Banks can go unscathed. So many Canadians label banks as conservative and stable securities. While they often do behave that way, one must accept the reality that banks are very highly leveraged profit machines. During periods of economic stability, they cannot help making large sums of money that they distribute generously to their shareholders through dividends. The problem is that when you have a highly leveraged balance sheet, during economic uncertainty, the leverage can dramatically work against them.

While I am not predicting an imminent decline, it is in my opinion that investors should educate themselves on option hedging strategies to manage unexpected risks. While hedging does have a cost, it comes at a benefit of reducing volatility and risk. As an example, we have an investor was to have owned 1,000 shares of CIBC for many years at an average cost of $60. With the stock trading at $95.00, the investor is concerned about the risk into the 3rd quarter. The investor buys 10 October $84.00 puts for $1.00 or $1000.00. Over that holding period the investor will receive two $1.06 quarterly dividends or $2,120 total. Essentially the investor is using a part of their dividends to remove the risk of a violent unexpected drop and put a floor under the stock limiting the risk to about a 10% draw down . A simple step like this can give the investor the confidence to hold the stock, even in uncertain market conditions. It is up to each investor to decide how to position themselves, but ask yourself a simple question - is the dividend and further upside worth the risk of being without a hedge?

Options Education Day: “The Road Ahead: What’s Next for Canadian Investors?”

Download Richard Croft’s presentation: The Road Ahead: What’s Next for Canadian Advisors? and discover what to expect in the coming months and how you can naviguate better the economic environment.

Understanding How to Exit before you Enter

Option trading is rarely static. Cost / benefit metrics can change quickly causing one to rethink whether the initial assessment underpinning a trade is still in play. Often follow up strategies are required to either minimize losses on trades that miss the mark or up the ante on profitable positions.

Ideally, follow up strategies should be set out before any new position is established. It’s important to establish a range of outcomes and what steps might be taken should the underlying security realign beyond initial expectations.

For example, let’s assume that three months ago, XYZ was trading at $23.50 per share. At the time, we will assume that XYZ August $25 calls were trading at $2.00 per share. A six month covered write would yield 16.3% if XYZ is called away and 9.3% if the underlying remains the same. Downside breakeven is $21.50. Decent metrics assuming you are mildly bullish about the short term prospects for XYZ.

Fast forward three months and XYZ is trading at $29 per share. Analysts have upped their price targets and the XYZ August $25 call is trading at $4.50. Most traders do not enjoy the positive experience of earning the maximum potential return. Instead, traders focus on the risks that underpin covered call writing. Which is to say, you lose the best performing stocks in your portfolio.

The XYZ example raises three very basic questions; 1) was your initial assessment that lead to the sale of the covered call reasonable? 2) has that assessment changed because of market or company specific conditions? and 3) are there follow up strategies that could be implemented to enhance the returns from the original position?

Follow up strategies come in two forms. There are repair strategies designed to minimize potential losses and enhancement strategies designed to increase the potential profit from a position. In this case circumstances dictate the latter approach.

The most common tactic is to roll up the covered call to a higher strike with either the same or longer dated expiration. In this case, re-purchasing the initial August $25 call at $4.50 and selling say the XYZ August $30 call at $1.00. The total cost to roll up the position is $1.50 (i.e. $2.00 + $1.00 from the sale of the two calls less the $4.50 cost to re-purchase the initial call).

The new covered write ups the potential return to 33.3% if the stock is called away or 28.9% if the stock remains where it is. But at the same time, it raises the downside breakeven to $22.50 per share.

An alternative to the roll up enhancement is to close out the initial position and replace it with a bull put spread. It all depends on a new assessment.

A bull put spread involves the sale of a put with a higher strike and the purchase of a put with a lower strike. The position produces a net credit and requires margin. However assuming the original covered write was paid in full, additional capital will not be required.

With XYZ at $29 per share, you could sell the XYZ August $32.50 put (valued at $3.75) and buy the August $27.50 put for $0.75. The per-share net credit is $2.50 with the downside risk limited to $2.50 should the stock fall back. However, you have already made $2.50 per share on your initial position so your overall risk at this point is negligible. No matter where the stock ends up!

The rub with either follow up enhancement strategy is the whipsaw effect should the underlying security fall. And that is the classic debate faced by option traders; does the underlying security continue to rally or regress to the mean?

Dealing with that debate is made more difficult if you have not given thought to exit alternatives at the outset. Decisions made in a vacuum often end badly.

TFSA Contribution Levels Raised

Announced late April, but effective as of January 1st 2015, Canadians are now entitled to contribute $10,000.00 to their Tax Free Savings Account on a yearly basis, up from $5,500.00 last year.  As of now, it makes the total contribution limit $41,000.00.

According to news sources, the Liberals are on record opposing this increase by the Conservative party and that they prefer the limit remain at $5,000.00.  Depending on how Canadians vote comes election time, this bump in contribution limits may be short lived, but for now it’s worth taking advantage of.

TFSA’s offer a shelter from taxation on profits generated on after tax dollars.  While taxes are paid on the capital before it is deposited, profits are free to grow, compound and be withdrawn without taxation.

While an RRSP offers the investor shelter from the immediate taxation of capital gains, tax will be paid upon withdrawal whereas profits from gains in a TFSA account can be withdrawn at any time and are not subjected to taxation.

Many investors are unaware that they can actually apply a number of option strategies in their registered accounts.

Since 2005, the following strategies have been permissible:

  • Buying calls as a stock replacement strategy
  • Buying calls to secure the purchase price of a stock you wish to own in the future
  • Buying puts to trade a bearish view
  • Buying puts for protection
  • Covered calls
While any of these strategies can offer the investor an edge over the traditional approach to managing their money, let’s consider the impact that the covered call strategy could have on the cash flow generated in a TFSA.
While stocks and exchange traded fund values may fluctuate up and down over the years, an investor implementing the covered call strategy could increase their non taxable income significantly.
Let’s assume that an investor is well diversified across multiple accounts and investments.  $41,000.00 in a TFSA may be considered risk capital and the investor is prepared to be a little more aggressive with the objective of achieving a higher rate of return.  Based on their analysis and expectations, they believe that Agnico Eagle Mines (TSE:AEM) is a good investment over the long term.  Having a substantial amount of diversified investments in other accounts, a $41,000.00 stake in this company represents a small portion of their overall net worth.
With TSE:AEM trading at $40.29, the investor could purchase approximately 1,000 shares.
I want to make it clear that I am not recommending that investors allocate all of their TFSA to one security.  Investors must consider their own personal circumstances and diversify their investments accordingly. That said, the covered call strategy could be applied to a basket of options eligible stocks spread across a number of different sectors. For the purpose of this example, TSE:AEM makes for an interesting consideration.  While the share price has been quite volatile, the option premiums have reflected this and are paying the covered call strategist generously for taking on the obligation to deliver the shares. As of Friday May 15th, the stock is trading at $40.29.  The June 2015 $42 call is bidding $1.15.
aem option chain
Selling this call against the shares of TSE:AEM obligates the investor to deliver the shares at $42 over the next 33 days. While the investor can profit on the shares by $1.71 if the stock rallies above the $42 strike, they have also generated $1.15 per share or almost 3 percent in cash flow.  On 1,000 shares, this represents $1,150.00 of tax free income in 1 month.
It is important to recognize that the risk associated with the covered call strategy lies with the underlying stock.  If the shares drop below the purchase price less any premium collected, the investor will be sitting with an unrealized loss.  Further to that, by selling close to the money calls, the investor has limited the potential upside.  Considering the risks, selling calls each month against the shares serves to mitigate the impact of a drop in the share price when an adverse move takes place. When the stock stays the same or increases in value, the investor has generated a respectable income on their investment.  This cash flow can be withdrawn tax free to be used at the investors discretion, applied to the purchase of additional shares or simply left to build up the free cash reserves in the account.
This example represents a covered call return that is on the higher side due to the volatility of TSE:AEM.  However, even on a diversified TFSA portfolio of options eligible stocks and ETF’s the compounding effect over the long term could result in a pretty impressive tax free return.

Hedging the Canadian Economic Recovery

On February 24, 2015, Stephan Poloz, Governor of the Bank of Canada made the following statement:

“The negative effects of lower oil prices hit the economy right away, and the various positives—more exports because of a stronger U.S. economy and a lower dollar, and more consumption spending as households spend less on fuel—will arrive only gradually, and are of uncertain size.” (Monetary Policy Report April 2015)

The TSX Composite Index has risen close to 1700 points since the December lows led by short term recoveries in the Canadian energy and banking stocks. At the same time, we have seen a first quarter bottom in the Canadian dollar at $0.78 with now a $0.05 recovery to the current levels. The recovery has been in part due to the more optimistic comments from Governor Poloz during the last Bank of Canada press conference.

While I won’t dispute that the Canadian economy has yet to demonstrate recessionary characteristics, there are some reasons why I am not sold on the recent turn back higher. So what do I worry about?

Irrespective of the recent bounce in oil prices, there has become a fundamental shift in the energy space. A recent Financial Post article suggested that the drop in oil prices has forced over US $114 billion in spending cuts. New projects have been canceled or put on hold. This does not change just because West Texas Crude trades to $60.00. These projects were a major source of jobs and investment banking revenues. These are not coming back overnight.

As stated at the start, Stephan Poloz suggests that this can be offset by a stronger U.S. economy, more exports and more consumption by households that are spending less on fuel. To me, these offsets are turning out to be duds. While our weaker dollar makes our exports more attractive, there isn’t much of a global recovery occurring around the world, so increases in gross exports are likely to be a monetary adjustment and not real growth. At the same time, the U.S. GDP numbers released today are showing almost no growth in the U.S. economy. Is that what we are counting on for a boost north of the boarder? The lower gas prices may not have the spending effect the BoC is hoping for. Heavily indebted Canadian consumers may use the lower gas prices as an opportunity to get their heads above water on what continues to be a very stressed household budget.

While I am not trying to be overly bearish, I simply do not see the current conditions as being ripe for a new economic growth cycle. At the same time, Canadian equities are vulnerable to a negative turn in European and American stock markets going into the 3rd quarter of the year.

I am not opposed to owning Canadian equities, but I am using the recent run higher in Canadian stocks as an opportunity lock in the advance with at-the-money protective puts, particularly on energy and bank stocks. Why? To me, unless you are really bullish on a Canadian recovery, the question is how can you justify not hedging the risks?

Optimizing Your Covered Call Strategy

Like a good dance lesson, writing covered calls is a two-step process. You need to be comfortable holding the underlying stock and should be happy if the stock is sold at the strike price of the short call. Having comfort with the underlying stock leads to the next step; which option to sell? Is there an optimum option to sell, should implied volatility enter into the decision, what about liquidity in case you want to buy the option back at a future date? These are fair questions to which there is, unfortunately, no right answer. Selecting which option to sell is as much art as science. The correct option is the best fit to your comfort index. For example, what strike price most closely aligns to your view of the underlying stock? What price are you willing to sell your shares? Or better yet, at what price are you unwilling to buy the shares? That is probably the strike price that most closely aligns with your comfort index. But then, what about downside protection? Certainly, you want the premium received to hedge some of your downside risk, which again plays into the strike price and time horizon. Simple rules of thumb tell us that aggressive traders want to leave room for upside potential and will probably write shorter term out-of-the-money calls. If you are positive about the underlying stock, write strikes that are further out-of-the-money. Of course being positive about a stock is a state of mind. If you are bullish and believe the stock has major upside potential, you probably should not be writing covered calls! Attempting to capture short term income using a strike that you do not think will be breeched does not work as often as you might expect. And if you are wrong about the stock’s potential, an out-of-the-money call provides little downside protection. Ideally, aggressive traders should only consider writing covered calls when they are mildly bullish or neutral on the prospects for the underlying stock. In which case, writing short term – i.e. one or two months to expiry – out-of-the-money calls would be the appropriate strategy. Conservative investors typically opt for downside protection by writing at or in-the-money calls with longer expirations. The value for conservative investors is the tax advantaged cash flow not the stock’s upside potential. The starting point for the aforementioned covered call strategies is that the investor is more focused on the underlying stock than with the option strategy. The covered call is simply a tool to manage the inherent volatility associated with the underlying stock. For investors who use covered calls as a core strategy, the underlying stock, while important, is not the end game. The cash flow from the sale of the calls is the beginning and the end of the strategy. The underlying stock is simply the vehicle that sets in motion the regular cash flow. Determining your comfort index and by extension the optimum covered call strategy depends on your investor profile – i.e. are you aggressive or conservative? – and whether covered call writing is a core or secondary strategy. Think about it this way. Your principal residence is where you live. You may rent out the basement occasionally, but any real return will come from the appreciation of the property. A rental property on the other hand, is an investment that is designed to provide a regular income stream with capital appreciation being secondary. Investors who use covered option writing as a core strategy have a different set of metrics when selling calls. They are keenly interested in seeing if the options implied volatility is compatible with their view of the underlying stock’s recent trading patterns. If so, does the option provide sufficient premium to justify buying the shares and selling the calls. Because the core writer is usually buying the shares and immediately selling the calls, liquidity is critical. Usually the close-to-the-money calls make the most sense because they are the most liquid and most closely reflect their fair value. The only other consideration for the core writer is time to expiration. We know with mathematical certainty that options lose most of their time value in the last three months prior to expiration. Time value erodes exponentially as the option gets closer to expiration. In short, core option writers should probably sell shorter term close-to-the-money options with less than ninety days to expiry.

Strategies for Income Investors seeking Yield

Income hungry investors continue to ramp up their risk appetite in order to collect extra basis points in yield. Bonds continue to defy gravity as foreign investors flock to the safety and higher yield in North American fixed income assets. Canadian bonds have turned in strong returns as witnessed by the iShares Broad Bond Universe (XBB) up better than 4% since the beginning of the year. There may even be more to come with sovereign debt issued by stronger European economies having slipped in negative territory. While it is difficult to imagine holding a security that guarantees to return you less money than you started with, these buyers believe the currency in which the sovereign debt is denominated will be stronger, which will more than make up for the negative yield. They may be right! With odds that Greece will exit the Eurozone and default on its obligations, there will be disruption in the Euro, which will inspire a flight to safety into stronger Eurozone partners and safe harbors like Canada and the US. The end result for Canadian investors; lower yields and higher prices for fixed income assets. The challenge for income seeking investors is that a higher price for fixed income assets means that the yield on these instruments will decline. And that does not take into account the punitive tax consequences for collecting interest income. Another approach is to look for equities that pay regular dividends. Dividends from preferred shares remain attractive although the value of many preferreds has not produced the kind of upside that we have seen with bonds. Most likely, because preferred shares are income producing equities where a missed dividend payment does not impact the corporations’ viability. A missed interest payment will force a company into bankruptcy. One preferred that I like is the Premium Income Preferred “A” (PIC.PR.A). This is a split share in a basket of major Canadian banks. The corporation buys a basket of Canadian banks and splits the potential growth (i.e. the capital share which owns the growth and dividend increases associated with the basket of banks) and an income stream (i.e. the preferred share which owns the preferential rights to the dividend stream paid by the bank basket). Think of the split shares this way; the capital share is a long term call option on the basket of banks while the preferred share is similar to a long term in-the-money covered call on the underlying banks. PIC.PR.A closed Friday at $15.36 and pays a quarterly dividend of .216 cents per share equal to a 5.63% yield. Since the underlying banks would have to fall precipitously for the in-the-money call to unravel, the yield is pretty safe. Keeping with that theme, you could implement a similar strategy by executing a longer term at-the-money call on a high quality dividend paying stock. Take BCE Inc. (BCE) as a case study. BCE pays a quarterly dividend of 65 cents per share which at current prices yields 4.82%. If you were to buy the shares at say $54.00 (Friday’s close $53.97) or better and write the January 54 calls, you would receive a premium of $2.15. For an income investor, this has appeal because the premium from the call option is taxed as a capital gain while the dividends receive preferential tax treatment via the dividend tax credit. The yield on this BCE covered call is 7.59% (annualized yield 10.30%) between now and the third week of January when the stock will most likely be called away. There is one caveat in that the BCE shares could be called away prior to the January expiration. That happens occasionally when selling in-the-money covered calls on stocks that pay above average dividends. However in this case that would simply mean that you earned your maximum profit early and could then enter a new in-the-money covered call using a longer term option.

Hedging a Diversified Portfolio

It is an accepted reality among investors that we are living in a global economy.  If you take a look at when most of the volatility in the equity markets has occurred, it is generally around a Bank of Canada (BOC), Federal Reserve Open Market Committee (FOMC) or an European Central Bank (ECB) rate announcement and subsequent press conference.  These kinds of risk are known as systematic risk and are based on broader geo-political and economic considerations.  The challenge is that it is difficult to hedge against this kind of broad based risk.  Many investors hold a diversified portfolio of companies representing different sectors. While this reduces the concentration of risk to any one specific market sector, there are times when there is no where to hide.  When an investor senses risk in any one stock, protective puts can be purchased to offset the potential loss.  Patrick offered some insight into this in his the post titled Have the Rail Stocks Been Derailed? This is known as unsystematic risk . This kind of risk can be managed with some cost effectiveness as puts need only be purchased on the individual stock.  The dilemma for the investor arises when there is concern for the entire portfolio in which case purchasing puts on all of the securities held may not be cost effective or even possible depending on options eligibility. I’ll be presenting at the Options Education Day in Vancouver on May 30th along with Patrick Ceresna, Richard Croft and Marty Kearny.  Click here for topics and registration details.  While there are a number of great topics lined up, my focus will be on “4 Ways To Hedge Against Risk”.  One of the approaches that I cover is the use of index options to hedge a diversified portfolio, more specifically SXO options. SXO options are priced based on the S&P/TSX 60.  For a complete overview of the contract specifications check out this Fact Sheet.  If the expectation is that a broad based market decline is going to impact the value of a diversified portfolio, rather then buying puts on each stock, the risk my be hedged by purchasing puts on the SXO.  As the broader market declines, the expectation is that the portfolio will drop in relation, the extent of which will be dependent upon the shares held in the portfolio and their weightings. In general, to calculate the number of SXO puts to purchase, the investor would use the following equation: Portfolio Value / (S&P/TSX 60 Value X $10.00), where $10.00 represents the standardized point value of the contract. This would offer the investor what is known as an imperfect hedge where a drop in the S&P/TSX 60 index may not be the exact same as a drop in the portfolio. To calculate the number of contracts that would more closely hedge the portfolio based on a drop in the index, the portfolio beta may be calculated.  The beta represents the amount of variance in the value of a portfolio comparative to the overall market. In this case, the S&P/TSX 60 is representing the “overall market”. With the beta of the index considered to be 1.00, a stock may have a beta higher or lower then 1 depending upon how correlated or uncorrelated it’s share price is with that of the market. You can calculate your portfolio beta by finding the beta of each stock, adding them up and then dividing that number by the number of shares in your portfolio.  If the shares have different weightings in your portfolio, you first multiply the beta by the weighting percent and then, execute the same calculation. To find the beta of a company, I use TMX Money and the “Get Quote” feature at the top of the homepage. Once this Beta number is established, the following equation would be applied: (Portfolio Value X Beta) / (S&P/TSX 60 Value X $10.00) One additional benefit of SXO options is that they are cash settled.  This means that the contract is settled for the difference between the strike price and the closing price of the index.  Rather than shares exchanging hands, if the option has any intrinsic value, it is deposited in to the investors account.  Comparatively, ETF and equity options are settled through the purchase and sale of the underlying shares.  For the investor who wishes to hedge the risk in their portfolio, but does not want to actually close any positions, this becomes an attractive solution.  As the portfolio value drops, the SXO option will offset a portion of the cash difference. Hedging is an important consideration in any investment plan.  Investors taking the initiative to manage their own capital need to be aware of the choices that they have to manage risk.  While the markets have continued to advance higher year over year, history has taught us that corrections are an inevitable part in the the stock market cycle.  By learning about SXO options and how to hedge a diversified portfolio, investors can be prepared to preserve their profits and protect their capital when market conditions change. For more information on portfolio hedging, please join us on May 30th for the Vancouver Options Education Day. For those of you that can’t make it, there are a number of videos available at www.m-x.tv to help you understand how to use SXO index options to meet a variety of objectives.