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.
The past 4 years have been great for railway stocks. The boom in energy and exportation of resources since 2011 has seen revenues and profits soaring. Investors that participated in this story have been handsomely rewarded with stocks like Canadian Pacific Railway having risen 400% off of its 2011 lows.
While I do not want to question the quality of Canadian railway stocks, all investors must recognize that the easy money has already been made and what were cheap rail stocks in 2011 are now relatively fully priced stocks in 2015. While a stock being fully priced is not a concern in itself, we must factor in the fundamental shift in the macroeconomic environment.
So what has changed? Oil.
The Canadian economy is resource based and has benefited from the growing infrastructure projects associated with fracking and oil sand production. As production started increasing, oil producers increased their reliance on rail as pipelines failed to keep pace with the surge. Some suggest that this has been as much as a 40 fold increase in carloads in just 5 years.
The problem now lies in the fact that oil prices have collapsed. The heavy bitumen oil produced from the oil sands has been particularly hit hard having recently dropped below $30.00. While the companies have started to cut spending, the oil is still flowing. The risk really is dependent on how long oil is to remain at or below these levels. Production may have to be curtailed inevitably, impacting the pricing power and quantity of oil shipped.
The second problem lies in the recent derailment accidents. There is now increasing government scrutiny which will lead to tighter regulations and increased costs as many railcars will need to be upgraded.
The bottom line is that there is increasing risk. So should you sell your shares? You could. Should you buy a put option as protection? You also could, but the cost is considerable if you are going out for a longer duration. From my perspective, implementing a collar strategy makes the most sense as I believe there is still some upside (though limited).
Let me illustrate using Canadian Pacific Railway shares:
- investor has owned the CP shares for many years and has a considerable capital gain if the shares are sold
- The stock is trading at $229.24 (March 27th, 2015)
- The collar is a combination of a protective put with a covered call. In this case we are buying the October $230.00 put for $17.50 or $1750.00 debit for every 100 shares.
- The investor then proceeds to sell an October $255.00 covered call for $7.50 or $750.00 credit.
The investor has now paid $10.00 or $1000.00 net for creating the collar.
What has the investor created?
The investor has created a scenario where they continue to enjoy the dividends and further upside of the stock up to $255.00. At the same time, they have a put contract that guarantees them a sale price of $230.00 if the stock was to begin to weaken. This gives the investor 6 months to see how the stock behaves. In addition, the investor delays having to make the decision to sell therefore defers the capital gains obligations. Considering the increasing question marks associated with the railway stocks, this is a great alternative for the investor that also allows them to sleep well at night knowing that if the bull market in railway stocks gets derailed, their profits and exit price have already been secured.
Back on January 30th, I posted a blog outlining a strategy to limit your risk for a longer term bullish position on TD Bank. For full details please reference What About The Banks? I suggested that with TD shares trading at $51.00, we could purchase call options at the $52.50 strike price expiring in January 2016 for $2.99 per contract.
On February 13th, TSE:TD shares closed at $55.50 and the January 2016, $52.50 calls closed at $5.20 which represents a 73% return on your risk…had you locked in your profits at that point.
In all fairness, I was looking at this as a longer term proposition. The intention was to stay exposed to the potential upside of TD Bank shares, while limiting the capital outlay and risk exposure. As a way to reduce the cost basis further, I suggested that in an unregistered account, we could sell near term calls against the longer term position. I looked at writing the February $54 calls and collecting $0.20. Since TSE:TD shares closed at $53.96 on the February expiration Friday, the $0.20 credit would be realized and the average cost of the position would be reduced to $2.79.
Now, following that approach, on Monday, February 23rd, The March $56 calls were bidding $0.26. Notice that with shares advancing in our favour, we have rolled the written contract strike up to $56. It now gives us the potential for an extra $2.00 appreciation in the shares before having to consider making any adjustments or closing the position. Our average cost basis at this point would be $2.53.
Since then, the shares have pulled back and currently trade at $53.20. There are now a few technical signs that indicate that we may see a continuation lower. For the novice technician, the easiest to identify is the break below the 200 day moving average as pictured below:
So we now have 2 choices:
1. Close the position:
The current value of the January 2016, 52.50 strike call is bidding $3.15. We could close the position profitably, however we can’t forget about the March $56 calls we wrote. They have to be bought back. The current ask for this contract is $0.05. We will basically be giving 5 cents of our 26 cent credit back. This brings the average cost of the January 2016 $52.50 calls to approximately $2.58. By closing this out today and moving to the sidelines, we would lock in 22%.
2.Buy a short term put:
If your intention is to hold the position for the duration, you can purchase a 1 month put option to hedge out any significant decline and possibly profit from a short term sell off. The April 52 strike put is asking $1.00. By purchasing this short term protection, we would be basically creating a calendar strangle. We are long the January 2016 $52.50 calls and long the April 2015 $52 puts. Considering the credit collected from the short term calls writes, the addition of the protective put increases our average cost to $3.53. If our expectation that the shares will reach $58.00 by January 2016 remains in tact, this still offers the potential for a 56% return on our risk. It is important to note that this will vary depending upon our option writing approach over the following months and whether the stock trades above our written strike in any given month. If the shares drop to $50.00 by the April expiration of the $52 puts, the put contracts will have an intrinsic value of $2.00. With the original cost being $1.00, the additional $1.00 profit now further offsets the cost of your long term call.
Regardless of which approach to managing this trade we choose, we have a number of solutions at our disposal to make adjustments. By using options as a replacement strategy to owning the TSE:TD shares, we have had a limited risk exposure from the start. In addition, as the market conditions change and our outlook on a position is questioned we can be proactive with locking in profits or modifying our risk exposure.
On January 15th, the Swiss National Bank (SNB - Switzerland’s central bank) removed its’ self-imposed restrictions on the Swiss Franc. A major shift in policy shrouded in secrecy at a time when central banks had been trying to be more transparent, which many felt would have dire consequences for the Swiss economy. Note the quote from Nick Hayden Chief Executive of Swatch a major Swiss exporter who opined at the time; “Today’s SNB action is a tsunami; for the export industry, for tourism, and finally for the entire country.”
The fallout from the SNB announcement was immediate. The Swiss Franc rallied 30% against the euro and companies like Swatch fell 16% as the cost of their goods destined for European buyers surged 30% in an instant. The Swiss stock market declined a precipitous 7% in one trading day.
Makes one wonder why a powerful central bank known for its conservative mind-set would appear to act so recklessly. It turns out that the SNB was caught between the proverbial rock and a hard place. It simply had no choice.
It was 2012 when the SNB initially pegged the value of the Swiss Franc at 1.20 to 1.00 euro. The self-imposed ceiling was intended to halt the Swiss Franc’s appreciation which was, among other things, causing problems for Swiss exporters. In hindsight, the January 15th SNB decision was a precursor to a €1.6 trillion bond buying program (i.e. quantitative easing or QE) announced by the European Central Bank (ECB).
As expected the euro immediately fell against the so-called safe have currencies such as the US dollar and of course the Swiss Franc. Clearly the SNB felt that it did not have the resources to defend its 1.20 to 1.00 euro peg against currency traders engaged in a flight to quality. Interestingly, all of this has taken place before the ECB has even begun printing the necessary euros to fund its’ bond buying endeavours.
Beyond the currency impact, I think the ECB has created an interesting opportunity. After two years of skirting the issue, the ECB has embarked on a program that will ultimately do what Mario Draghi has always said he would do; defend the Eurozone at any cost!
That is not to suggest that we will see a bump in Eurozone economic activity because, like the US experience, I suspect the ECB bond buying program will end up strengthening the balance sheets of European banks and probably light a fire under the various Eurozone stock markets by expanding P/E multiples and bolstering stock re-purchase programs.
To that point, traders are reminded of the 2013 rally in US stocks following the October 2012 announcement by the US Federal Reserve of QE-III. Since the ECB’s program is similar in size to QE-III, we may see some decent gains in European stocks during 2015.
The challenge is to take advantage of a surge in European stocks while hedging out the risk of a declining Euro. One product that comes to mind is the iShares MSCI EAFE Index ETF (symbol XIN, Friday’s close $24.48). XIN is not a pure play but it does provide exposure to European stocks and hedges the currency back to the Canadian dollar.
XIN has already rallied 9.97% since the beginning of the year but I think there is more to come. I note for example that money managers are warming to the idea of a stronger Eurozone in 2015. More than a few have opined that European stocks look relatively inexpensive when compared to the S&P 500 Index. And with the bond buying program just beginning, we should see it impact Eurozone stocks as the snow begins to melt.
Aggressive option traders might consider buying some longer term in-the-money calls to take advantage of this scenario. Specifically look at the XIN September 24 calls at $1.25.
Canadian investors started the year with a pleasant surprise as the Canadian market and many Canadian stocks performed relatively well. We suggest a little digression to understand the precipitating factors that have driven this rise.
Over the last 6 months, we have seen a dynamic shift in Canadian economics. Canada has been relying heavily on the resource sectors to drive the wealth of the nation. As the resource, particularly the energy sector, plummeted over the last half year, a number of significant concerns were exposed. One only has to look to the Bank of Canada (BoC) and its significant shift in monetary policy to understand the need for immediate action to stabilize the situation. Without going into the specifics, the key observation that must be observed is the divergent monetary policy between the Federal Reserve and the BoC. This divergence has been one of the key drivers in the substantial decline of the Canadian dollar. This currency trend has been significant enough to make a material impact on equity prices in the Canadian market.
In fact, one can attribute much of the rise in the Canadian stock market to the serious decline in the purchasing value of the Canadian dollar. To give a few examples:
- iShares MSCI Canada Index Fund ETF (US Dollars) – Year-to-date: -(2.30%)
- ishares S&P/TSX 60 Index ETF (Canadian Dollars) – Year-to-date: +4.50%
- BCE shares traded in New York (US Dollars) – Year-to-date: - (3.78%)
- BCE shares traded in Toronto (Canadian Dollars) – Year-to-date: +3.12%
If you are like the average Canadian investor, you are overweight Canadian equities in Canadian dollars and due to the decline in our dollar; we have seen a currency induced/adjusted advance in equities. In order to remain strongly bullish Canadian equities, you have to believe in one of two themes. One, there is a strong economic recovery around the corner for the Canadian economy, or two, the currency will still make a considerable decline towards $0.75 or $0.70 against the U.S. If you are in one of those camps, you can stay long. But if you believe the majority of the currency move is behind us and that the Canadian economy will struggle in the year ahead, this is a great time to employ yield enhancing strategies.
One yield enhancing strategy is to sell out-of-the-money covered calls for a longer duration like 6-12 months. These premiums allow you to create returns without needing further appreciation in the underlying stocks. In addition, the premium received can act as a hedge to reduce the volatility of your portfolio.
As an example, the XIU – iShares S&P/TSX 60 Index ETF, is trading at $22.61. That is over 10% higher off its $20.50 lows in January. An investor that feels there is only marginal upside can sell a September $23.00 covered call is bidding $0.60 or 2.65% cash flow premium.
This is only a good idea for those investors that remain skeptical of the further upside of the Canadian market. At minimum, it is a strategy that could be actively deployed in the upcoming months once the market momentum has started to slow into the historically weak summer months.
Back at the end of January, Richard Croft posed the question “Has Oil Bottomed?“. At the time of publishing, oil was trading at around $46.00 per barrel. In his article, he cites a number of supply and demand and geo-political considerations supporting the potential for range bound trading activity between $40.00 and $60.00 per barrel through out 2015. He offers the covered call strategy as a way to take advantage of increased option premiums due to volatility and enhance cash flow as some of the big name energy companies share prices consolidate and advance slowly higher.
This is a great approach for a more passive investor. However, I think there may be an opportunity to take advantage of a short term upswing in oil for the more active reader.
In addition to Richards considerations, I would also look at the trend of the U.S. Dollar. If we plot the U.S. Dollar Index against Light Sweet Crude Oil, you will notice the inverse relationship of the two. Since commodities in general are priced in U.S. Dollars, when the USD is strengthening, commodities tend to weaken and vice versa. Of course, from time to time, supply and demand forces and geo-politics will exert an influence. However, the weekly chart below clearly reflects the inverse relationship.
With this in mind, we need to recognize that the strength of the U.S. Dollar has been largely influenced by the uncertainty in the Euro. The European Central Bank decision to launch a U.S. style quantitative easing program forced a continuation lower in the Euro. However, in spite of the recent Greek elections and the looming threat of a Greek exit from the Euro-zone, it appears as though the Euro has priced in the threat.
My expectation is that the Euro is due for a retracement, and while we are not likely to see a change in the longer term down trend, we should see traders covering profits and short-term bulls jumping in and buying the up-swing. This will force the U.S. Dollar lower as a reciprocal currency. As the U.S. Dollar retraces lower, we should see a jump in commodities and more to the point of this article, oil. Traders have been benefiting on the short side of oil. As it becomes more evident that a short term bottom may be in place, there will be a period of short covering, which I suspect has already started. Short covering involves the buying back of the short position, which creates demand and influcence prices higher. This can often be a very volatile process.
The challenge is that with so much uncertainty in world of geo-politics and the currency wars raging on, calling a short term bottom in oil is like trying to catch a falling knife and I would add, a slippery one. However, the business of trading and investing is all about risk and reward. It is impossible for us to predict where the exact bottom of oil is but if we believe that there is the potential for a move higher, taking a decisive stance at current levels may yield an attractive return. Over the near term we can look at using a call option to gain exposure while limiting the risk to a defined amount if we are wrong.
HOU is the Horizons BetaPro Nymex Crude Oil Bull Plus Fund ETF. This Exchange Traded Fund provides the investor with a 200% exposure to the daily performance of light sweet crude oil futures. Now, this is a leveraged ETF which means that it can be volatile both in potential gains and potential losses. For more details on this product you can visit the Horizons BetaPro Nymex Crude Oil Bull Plus Fund ETF info page.
Using an 8 and 21 day Exponential Moving Average we can see that the prices of the HOU are starting to consolidate above the lines. This is something we have not seen for quite sometime. It is an indication that there is a potential change in trend taking place.
To take a “shot” at a continuation to the upside with a limited and identifiable risk exposure, you could consider a June $10.00 call on TSE:HOU for $1.70. With the shares currently trading at $9.55, this would be an at-the-money option. This move higher could happen over a much shorter time horizon. However, given the volatility and uncertainty of the oil market, allowing for several months for the trade to play out offers the trader a certain level of comfort.
Keep in mind that this is not a “buy and hold” type strategy. As the shares of TSE:HOU move towards the $15.00 range, it would be appropriate to consider locking in profits. This approach offers the active investor a way to take a decisive stance on a move higher in oil, with a limited and denifiable risk exposure and without limiting profits
This past week we saw some indications that longer term interest rates may actually rise. Something investors have been talking about for the past two years!
It is not that interest rates will rise significantly, it is more about what impact any change in mindset will have on your portfolio. More importantly, what steps can one take to manage interest rate risk?
What we know is that higher interest rates mean lower bond prices. Think about interest rates and bond prices as opposite ends of a teeter totter. Duration also plays an important role as longer term interest rates and bond prices will be more volatile than shorter term rates and prices i much the same way as a longer teeter totter moves more dramatically than the shorter version.
Higher interest rates do not affect stocks in the same way. Insurance companies for example, may be hurt by rising rates if they have a significant portion of their investment portfolio geared to annuities. Mind you that depends on whether annuitant recipients have options in terms of exiting contracts. On the other hand, it helps their life insurance business because they can earn higher returns on the portion of their capital tied to death benefits.
If interest rates do rise significantly, it can have a negative impact on auto dealers and furniture companies who have to pay higher costs to maintain their inventory. On the other hand, it would have little impact on grocery store chains that turn over inventory rapidly.
Banks typically benefit from higher interest rates especially if rates rise faster on the mid to longer end of the yield curve. Banks typically borrow money at the shorter end of the curve to finance mortgages at the mid to longer end of the curve.
We witnessed some of the advantages from higher rates flow through to Canadian banks over the past week. All of Canada’s major banks turned in some decent performance and I suspect we will see more of the same over the next few months. With that in mind banks provide the twin benefits of an excellent hedge against the possibility of higher rates and solid dividends should you have to buy and hold. Any of Canada’s major banks would fit the bill if you buy into this scenario.
A couple of ways to play this; 1) buy the shares and write slightly out of the money calls with two to four months to expiry or 2) for more aggressive traders take a look at buying longer term calls for capital appreciation with limited risk.
As an example you could look at buying shares of Bank of Montreal (symbol BMO, Friday’s close $78.69) and writing the April 80 calls at $1.70. The two month return if exercised is 3.83%, return if unchanged is 2.16% and downside protection is $76.99.
The other option is to buy BMO January 78 calls at $5.40. These calls are 89 cents in-the-money and will be profitable if BMO is above $83.40 by the end of the year. They may also be profitable in the interim should BMO spike on any news of higher rates.
A number of the big name oil companies are reporting earnings this week and many analysts think that the numbers may be worse than expected, which is to say worse than numbers that have already been revised downward.
Still, this is one case where you might want to take the numbers with a grain of salt. Let’s face it, tighter margins and lower earnings will reflect what everyone already knows. Despite one day surges like we saw last week, oil is unlikely to move substantially beyond its current US $40 to US $60 trading range for the remainder of 2015.
In my mind, the real story is how consumers have shrugged off lower oil prices. In my last column, I posited that North American consumers may have caught the savings habit and while that is one explanation, there is another possibility. It may be that consumers’ predilection to save has more to do with disbelief than a desire to strengthen their balance sheets. In other words, consumers are reluctant to accept that oil prices will remain at these depressed levels.
The longer oil remains within its current trading range, the more likely consumers will suspend their skepticism. That could lead to a surge in consumer spending in the second or third quarter of 2015, which would go a long way towards providing the kind of oomph that the economy needs. And by the way, be positive for North American equities.
Another consideration that should be factored into this mix is the Bank of Canada’s (BOC) recent interest rate cut. Clearly the BOC is comfortable with a low Canadian dollar, which, in the long run, keeps our exports competitive at a time when the rest of the world – the Eurozone, Japan and China – is engaging in all out currency wars.
What we have then is a triple threat;
1) consumer skepticism
2) low interest rates
3) a weak loonie
A couple of companies that can benefit as the threats dissipate are Canadian National Railway (Symbol: CNR, Friday’s close $83.72) and Canadian Pacific (CP, $221.81).
If this is a second half story, speculative traders might look at buying calls on these companies. The CNR September $84 calls at $6.10 (implied volatility 22%) and the CP July $220 calls at $19.10 (implied volatility 27%) look interesting.
You could also consider bull put spreads as the calls may be a bit too pricy for some traders. With CNR, you could sell the September $84 puts at $6.50, while buying the September $76 puts for $3.30. This spread generates a net credit of $3.20, which is if the stock closes above $84 in September causing it to expire worthless. The maximum risk will occur if the shares close below $76 in September. In that case, you would be required to buy shares of CNR at $84, but would have the right to sell the shares at $76. The maximum risk is the difference in strike prices, $8.00, less the net $3.30 credit received or $4.70 per share.
With CP, you could sell the July $220 puts at $16.25 and buy the July $200 puts at $8.75. Assuming you can get these prices, the spread generates a net credit of $7.50. If CPP closes above $220 in July, both options will expire worthless and you will retain the net credit. The maximum risk occurs if the shares close below $200 in July. In that case, you would be required to close out the position at a price of $20 per share, which would be a loss of $11.25.
Since my colleagues have already discussed Canadian Investors’ favorite topics, oil and gold (see Has Oil Bottomed? By Richard Croft and Is the Divergence in Gold and Opportunity? by Patrick Ceresna), I thought I would take a look at Canadian banks.
Canadian banks have no doubt come under pressure, dropping an average of 15% from the re-test of the 2014 highs, back in December, to their recent lows. Most of this can be attributed to investor concerns over the fall out from declining oil prices. Concerns have been based on an expected disruption in several lines of business. This includes a decline in underwriting revenues, derivatives risk exposure and possible default in uninsured mortgages, home equity lines of credit and credit card payments in the oil producing provinces.
To add to the pressure, the Bank of Canada lowered interest rates by 25 basis points last week. As a result, Canadian banks lowered their lending rates. The issue with this is that the banks rely on the spread between what they can borrow at versus what they can lend at. As key interest rates drop, the spread tightens and profits suffer. Interestingly enough, the 6 major banks only adjusted by 15 basis points in an effort to protect the already low lending margins. In addition, forecasts are pointing towards lower economic growth in 2015, which further adds “fuel to the fire”.
Investors have a habit of over compensating for the unknown. While there are still many unknown variables, it does appear as though bank share prices in general may be stabilizing at these current levels. Let’s take Toronto Dominion for example (TSE:TD). According to marketwatch.com, many analysts are rating TD as a buy and share prices appear to be finding some support at $50.00, which is a previously tested low. As a side note, the charts look considerably different on the NYSE due to the currency consideration. A factor that deserves significant attention as a Canadian investing in U.S. securities.
With TD earning due out on February 26th, we will see just what impact the lower oil prices and poor economic forecasts have had on the companies last quarter.
Many investors are motivated to own Canadian bank shares because of the stable dividend stream they provide. However, with uncertainty looming, using a call option as a stock replacement strategy offers the investor the right to own the shares at these depressed prices with a limited risk exposure. While the option buyer does not have the right to the dividend, it is important to note that dividends are already priced in to the value of the option. This actually reduces the cost of the contract from what it would be if the stock did not issue a dividend. In addition, the potential risk of holding the underlying shares may not initially be worth the 4% dividend yield.
With this in mind, we could look at purchasing a call option on Toronto Dominion (TSE:TD) ahead of the February earnings. In this example, I want to look at holding a longer term position in TD into 2016. This will allow me to benefit from any share appreciation over the year, but limit my risk exposure to a fixed amount during times of uncertainty. If the shares take off at any point and are trading above the strike price I have selected, I have the right to take possession of the stock.
With TD shares trading at $51, we could purchase a call option at the $52.50 strike price expiring in January 2016 for $2.99 per contract. This represents our maximum risk on the shares for almost an entire year. It is important to note that our break-even point is $55.50 per share. This means that on expiration, the shares must be trading above $55.50 for the position to be profitable. By using the option as a stock replacement strategy, we limit our risk on the shares to approximately 6%, when considering today’s prices. Compare this to an unidentified risk exposure for the out right share holder.
If, for example the shares finish the year at the previous high of $58.00, the option would have an intrinsic value of $5.50. This is determined by subtracting the strike price of the option ($52.50) from the settlement value of the stock ($58). This reflects a 84% return on risk.
For the income focused investor, outside of your registered accounts, you can implement the calendar spread strategy. While holding the longer term call option, you can sell out-of the-money calls to generate a monthly cash flow as you would in a covered call strategy.
For example, while holding the January 2016, $52.50 strike call, you could sell the February $54 strike call for $0.20. If you can collect this kind of premium on a regular basis, you will significantly lower the average cost of your longer term option and subsequently reduce your break even point on the shares.
The trade off with this approach is that if the shares jump beyond the written strike, you may be assigned to deliver them. In the example above, as the stock approached $54, the investor may be motivated to buy the written call back and roll the position by selling a call at a higher strike and further out expiration date.
If you are interested in owning TD at these levels, consider the longer term call option purchase as way to gain exposure with a limited and identifiable risk for almost an entire year. Of course if shares continue lower the option always be sold for a partial loss rather than holding out until expiration and risking the option expiring worthless.
Regardless of how you manage or modify the position, the longer term call option offers the investor the ability to take a decisive stance on a stock and weather some of the short term uncertainty with a limited and identifiable risk exposure.
Trading in the first quarter of 2015 will center on oil for good reasons. Not only has oil’s fall created one of the largest tax cuts since Reaganomics, the fallout has far reaching implications across a broad spectrum of industries.
Interestingly, at US $105 per barrel, it was obvious to anyone who understood supply and demand that oil was overvalued and demand will not likely drive oil prices higher as it is at best, stable with a slow bias to the upside.
Supply on the other hand has been rising at an almost exponential pace. Particularly as fracking technology has allowed the US to get at supplies that were previously unattainable. There is a view that U.S. and Canadian operations may be taken off stream as prices continue to decline. At present, most of the major wells remain in play likely because the estimated cost of production is somewhere between US $30 and US $45 per barrel. This is not as profitable based on recent prices, but margins that are sufficient to maintain current drilling operations.
The question is where do we find a bottom? My best guess is that we may have already put in a bottom and will likely trade in a range between US $40 and US $60 per barrel throughout 2015.
The one view everyone seems to share is that oil price declines benefit consumers. Perhaps, but those benefits seem to have been misplaced as consumers were reluctant to spend over the holiday season. Is it possible that consumers in the US and Canada have developed a savings habit?
We also know that a disruption within any sector leads to a domino effect across the economy often with unpredictable consequences! For example, we know that the Russian economy is imploding. That’s a dangerous environment when you have powerful politicians seeking to retain power in a declining economy that has no safety nets.
Veteran traders may recall April 2nd, 1982 when Argentina laid claim to the Falkland Islands, ultimately sparking a ten week war with the United Kingdom. The Falkland War was not about claiming territory in the South Atlantic, it was about deflecting attention away from the hyper-inflation that lead to rioting and civil unrest within Argentina. In the end, Argentina suffered a major defeat on the battlefield but got its desired result by focusing the country’s attention on the war effort and away from domestic problems. I am not suggesting that Russia will engage in the same kind of mind games,but you have to think that Ukraine is a potential pawn should things worsen.
The same story is true in Venezuela, that has already imploded and will most certainly face civil uprisings. More importantly, the Middle East, where major producers like Saudi Arabia have enormous fixed costs that cannot be honored unless the country continues its current output regardless of the longer term consequences!
On the positive side, we have seen movements in Iran away from their nuclear ambitions, which is clearly driven by their desire to further the domestic agenda in an environment of lower oil prices. In fact, we may see a politically motivated agreement forged in the months ahead that only six months ago would have been impossible.
On an economic level, there is no doubt that oil producing regions of the US will suffer as will the Canadian economy given oil’s roles as one of the three pillars that drive Canadian GDP. However, it may not matter much when you consider the power that oil wields on the political stage.
Oil is one of the world’s great equalizers. Long employed by oil producing countries to influence their political agenda, I suspect the US will be reluctant to ratchet down production for fear of losing a big stick.
When you think about it in those terms, it is clear that the US has been wielding a big oil stick with some clear results. As mentioned, Russia is imploding based on the fall of the Ruble, Venezuela’s economy is on the verge of collapse and the OPEC countries no longer have any real influence on the world markets.
Same goes for the US fight against terrorism. The best way to stop a radicalized fringe groups is to stop funding them. As North America becomes less dependent on foreign oil, it creates an interesting political backdrop to enact these types of policies.
If we accept the twin premise that oil has 1) put in a bottom and 2) is unlikely to rise sharply during 2015, traders may want to look closely at covered call writing on some of the larger energy names. The recent volatility that has sent option premiums higher across the energy sector make this strategy especially appealing.
Some stocks to consider as covered writing candidates; Crescent Point Energy (Symbol: CPQ, Friday’s close $30.07). Selling the April $32 calls at $1.65, Canadian Natural Resources (CNQ, $35.51), selling the May $36 calls at $2.90 and Imperial Oil (IMO, $47.43) selling the May $48 calls at $3.20.