Stepping Into Energy

Is the energy market becoming energized? It is a tough question laden with ambiguity. Evidenced by reams of well thought out research where slight changes in the inputs can shift the bias from bull to bear and back again.

Interesting the foundation for most of the research concentrates on output. How much supply OPEC and non-OPEC producers are expected to bring to market! The challenge is that this dataset is volatile and fraught with political bias.

What we do know is that 1) supply is outstripping demand and 2) OPEC will continue to maintain output at a level that will rein in competition both inside OPEC (i.e. Saudi Arabia vs Iran) and across non-OPEC regions (i.e. Russia and North America).

What we don’t know is 1) where oil prices will go in the short to medium term and 2) whether small to medium sized Canadian companies can survive at the US$40 per barrel price point.

Investors wanting to trade aggressively in this space need to understand that normal influences between supply and demand have given way to political grandstanding. Which is to say the energy market is drifting in some very rough waters.

For aggressive traders wanting to increase exposure within the energy space, think about short to medium term strategies. Work with the underlying volatility by dollar cost average your way into a new position.

With that in mind let’s re-visit a strategy talked about a couple of weeks ago (see “Bombardier Covered Straddles,” April 18, 2016). The goal is to implement covered straddles using a couple of small to mid-sized energy names. With the caveat that you should be willing to own the underlying shares for up to a year as the position matures.

The first name is Crescent Point Energy (TMX: CPG, Friday’s close $21.14) which yields 1.70% because of a monthly distribution of 3 cents per share. To highlight the risk associated with this sector consider that CPG was paying a monthly distribution of 23 cents per share in July of last year.

According to the TMX Money website, Crescent Point Energy Corp is involved in acquiring and holding interests in petroleum and natural gas properties and assets related through a general partnership and wholly owned subsidiaries.

With CPG you could look at buying the shares at $21.14 and writing the in-the-money July 20 calls at $2.15 and at-the-money July 20 puts at $1.05. The combined premium from the sale of the call and put is $3.20 per share.

The short calls obligate you to sell your shares of CPG at $20 per share until the third Friday in July. If CPG remains the same or rises it will be called away at the $20 strike price. The eleven week return assuming the stock is called away is 15.14%.

If CPG closes below the $20 strike price in July the CPG July 20 puts will be exercised and you would be obligated to buy an additional block of shares at $20 per share. At that point you would own twice as many shares as were initially purchased and your average cost for the CPG shares would be $18.97.

The second name is Precision Drilling (PG, $6.51). This is a small cap company that does not pay a dividend. The company provides drilling equipment for oil companies in Canada and the US and specializes in providing onshore drilling services in conventional & unconventional oil & natural gas basins in Canada and United States.

The PD straddle works much the same way as you would buy the shares at $6.51 and write the PD July 6 calls (90 cents per share) and PD July 6 puts (38 cents per share) for a total net premium of $1.28 per share.

If PD is above $6.00 per share by the third week in July the calls will be exercised and you would deliver your shares to the call buyer. That would complete the trade. The eleven week return from the sale of the shares is 19.66%.

If PD closes below the $6 strike price in July the PD July 6 puts will be exercised and you would be obligated to buy an additional block at $6 per share. At that point you would own twice as many shares and an average cost of $5.62 per share.

By selling the straddles we as using volatility to establish a low cost initial position with excellent return potential. At the same time we are instituting a mechanism to average down the cost base should the market decline over the short term.

Evaluating Earnings Variability

We often hear about the expected movement in a stocks’ share price based on an upcoming earnings release. Calculated as an implied trading range by reverse engineering the option pricing formula.

Traders typically use some version of the Black Scholes option pricing model to calculate the theoretical fair value for a call and a put on the underlying stock. Inputs such as time to expiry, current stock price, strike price, risk free rate of return, expected dividends payable by the underlying stock and of course, volatility. The latter input being the variable – i.e. best guess – within the pricing model.

Reverse engineering involves plugging the option price into the formula and asking it to solve for volatility. This output is the option’s implied volatility which is to say, what volatility input is required to generate the current price for the option. When analysts tell us that an upcoming earnings release could move a stocks’ price up or down by 10% they are basing that comment on the implied volatility calculation.

An easier way to arrive at the similar analysis without having P.H.D. in mathematics is to look at the current price of the near term at-the-money straddle on the underlying stock. A straddle involves the simultaneous purchase or sale of a call and put at the same strike price with the same expiration date.

A straddle buyer wants the underlying stock to move far enough to cover the cost of both options. The seller of a straddle wants the underlying stock to trade within a range bounded by the total premium of the call and the put. With either approach the trader is making a bet as to expected volatility prior to the options expiry. Neither is a directional bet on where the underlying stock is expected to trade.

To bring some perspective to this discussion let’s look at the expected price range for a stock where there is an impending earnings release. For example, BCE Inc. is reporting earnings next week. The consensus estimate for quarterly earnings is 85 cents per share.

BCE Inc. is a large blue chip company with a long history of paying and more importantly, increasing quarterly dividends. As such the earnings estimates provided by analysts tend to be clustered in a tight range. Very different from say, a company like Teck Resources that is also reporting next week.

To calculate the projected price range for BCE Inc. based on the upcoming earnings number we would look at the near term (i.e. May expiration) at-the-money straddle. BCE closed Friday at $58.48, so the closest at-the-money strike is $58.00. Based on Fridays numbers the BCE May 58 call was trading at $1.05 with the BCE May 58 put at $0.55. The total value of both options is $1.60 per share.

The next step is to add the total cost of the straddle to the strike price so that we have an upside target of $59.60. If we subtract the $1.60 from the strike price we end up with a downside number at $56.40. That is the expected trading range of BCE between now and the May expiration which in percentage terms, is a range of 2.736%. Quite low based on the expected earnings number.

Applying the same math to Teck Resources (TMX: TCK.B) where there is a rather large spread in the expected earnings data we get a much different picture. TCK.B closed Friday at $13.17 per share which makes the May 13 strike the best match to come up with a possible trading range.

The TCK.B May 13 call was trading at $1.40 with the TCK.B May 13 put at $1.25. Total cost for the two options is $2.65 which gives us a trading range of $10.35 and $15.65. In percentage terms that is a 21.121% trading range between now and the third Friday in May.

As we are well into first quarter earnings season option traders can play this variability where the payoff will depend on whether the company matches, beats or misses their EPS expectation.

Strategically companies do their best to guide analysts’ to a reasonable expectation. The objective is to guide estimates to the lower end of a range so that management can beat expectations. Easier for management to take a congratulatory lap rather than trying to explain a failed quarter.

Of course many factors are beyond the control of management. The sharp decline in oil prices being a recent case in point. The variability of gold prices and commodities in general being another factor.

On the other hand, companies like Thompson Reuters and BCE Inc. have relatively stable earnings streams allowing managements to provide guidance that is more often than not within basis points of the end number.

The options market is very good as calculating just how variable quarterly earnings might be. This can be useful information for investors looking to implement a new position, hedge risk into an earnings release, or to speculate on whether the company is likely to hit or miss on guidance.

With that in mind here is a list of companies who will release earnings this week. I have included the consensus earnings number as well as the implied trading range based on May at the money options.

Stock Price Range Percent At-The-Money
Symbol Price Up Down Range Calls Puts Strike Est.
TCK.B $13.17 $15.65 $10.35 20.121% 1.40 1.25 13.00 -0.09
PD $6.00 $6.78 $5.22 13.000% 0.40 0.38 6.00 -0.15
AEM $52.39 $57.10 $46.90 9.735% 2.75 2.35 52.00 -0.03
ABX $20.41 $21.68 $18.32 8.231% 1.05 0.63 20.00 0.09
HSE $18.05 $19.45 $16.55 8.033% 0.75 0.70 18.00 -0.23
G $21.65 $23.66 $20.34 7.667% 0.66 1.00 22.00 0.03
CVE $19.24 $20.43 $17.57 7.432% 0.83 0.60 19.00 -0.38
POT $22.72 $24.66 $21.34 7.306% 0.70 0.96 23.00 0.23
SU $36.30 $38.03 $33.97 5.592% 1.18 0.85 36.00 -0.22
SJ $46.56 $48.25 $43.75 4.832% 1.45 0.80 46.00 0.51
CU $35.05 $37.65 $34.35 4.708% 0.20 1.45 36.00 0.62
TRI $51.70 $54.30 $49.70 4.449% 0.85 1.45 52.00 0.60
CNR $83.45 $87.30 $80.70 3.954% 1.40 1.90 84.00 0.93
BCE $58.48 $59.60 $56.40 2.736% 1.05 0.55 58.00 0.85

Hedging Hope

Those that regularly follow my articles and forecasts can easily ascertain that I am a worry wart.  Fortunately, or unfortunately I am always skeptical on overly optimistic views on stocks and the economy.

So what am I skeptical on now?

I am skeptical on the supposed turn around in the Canadian economy. Yes, things have improved over the last quarter, but I simply do not think that the fuel for this turnaround is sustainable. The global economy has extraordinary challenges ahead of it, which is likely to act like a cold wet blanket on the recent hot commodity market. Yet, traders and investors are looking at the January lows as the end of the commodity bear market and have been buying in sheer madness, driven by the fear of missing a perceived bottom.

This entire cycle is predicated on HOPE.

Hope that the worst is over in China, hope that Europe remains stable, hope that the U.S. does not fall into a recession, hope that global demand for commodities begins to manifest itself.

I ask- what if this “HOPE” is just wishful thinking?

Personally, I want to hedge that hope. It is not about panicking or shorting the markets, it is more about recognizing that this rally may not have the underlying fundamentals to support a sustainable expansion.

So what can we do?  Protect oneself.

Let’s look at an example. I want to focus on Canadian banks with an example using Royal Bank.  The Canadian banks have had a great start to the year.  Royal Bank has traded as low as $64.00 in January and has now recovered $14.00 from its lowest levels and is now pushing new 52 week highs at $78.00 a share.  This financial recovery has occurred at the same time as many European, Chinese and Japanese banks face extraordinary headwinds and many U.S. financials that still remain well off their previous highs.  These Canadian banks are somehow trading like we are in the midst of a new commodity bull market and that all of the risks from energy company loan defaults have somehow been averted.

In this example, we have an investor that owns 1,000 shares of Royal Bank and is focused on dividends and longer term appreciation.   After having experienced the $14.00 rise in share value over the last 3 months, this investor is looking to hedge the downside risk and lock in recent gains.  So what can our investor do?

  • Investor owns 1,000 shares of Royal Bank valued at $78,000.00
  • Investor buys 10 June 17th $76.00 put options
  • The options are asking $1.10 (April 29th 2016)
  • The investor pays $1,100.00 for the puts ($1.10 x1000)

What has the investor accomplished?

By having spent some of their profits on buying the puts, they have secured a guaranteed sale price of $76.00 per share over the next 6 weeks.  If the investors’ concerns of a drop are unfounded and Royal Bank shares continue to rise, the investor still owns the shares and has 100% of the upside. Alternatively, if the market reverses and heads lower, the investor has a protective put that removes all downside risk below $76.00 between now and June 17th.

Some buy and hold investors are willing to expose themselves to unconstrained downside risk, but personally I always feel most comfortable being invested knowing that the risk is managed and the worst case scenario has been hedged.

A Bombardier Covered Straddle

There is little doubt that Bombardier (TSX: BBD.B, Friday’s close $1.62) is on life support. At issue is the diagnosis. Does the company follow in the footsteps of Blackberry to survive as a shadow of its former self? Or does the company collapse under a mountain of debt and litigation in much the same way as Nortel?

Unfortunately, no one knows which is why Bombardier is not a stock for long term investors. However, the BBD class B shares have options and under the right conditions there may be short term opportunities for aggressive speculators.

What we do know is the Bombardier is caught in the middle of a fierce tug of war between bulls and bears. The company manufactures excellent products with a solid market in Canada. Not so much in other parts of the world. Particularly when it comes to subway trains and executive planes.

Despite the problems Bombardier class B shares are up more than 100% since mid-February when they hit an all-time low of $0.72. Some might say this is simply a bounce from a longer term bear trend… although bounces do not normally end with tripe digit advances.

Bulls might argue that Bombardier is a turnaround story! Although not many would take a long term stake expecting to see a return to better times. More likely they are hoping the company wins enough contracts to remain viable.

That latter point is critical. A viable Canadian manufacturing company based in Quebec providing good paying private sector jobs carries a lot of political currency. Is it possible that the Federal government and Quebec Legislature might look at Bombardier as politically, if not systemically, important?

What we have then is a low priced stock with available options and no discernable long term trend. Makes an interesting case study for a short term covered straddle. I say that because holding BBD.B shares while selling both calls and puts with the same strike price and expiration date is a volatility trade; not a directional trade.

For example, you could buy say, 1,000 shares of BBD.B at $1.62 per share while selling the BBD.B May $1.50 calls (trading at 25 cents per share) and BBD.B May $1.50 puts (trading at 14 cents per share). The sale of both the calls and the puts will net you 39 cents per share in premium income. The long stock covers the short calls while cash or margin secures the obligations attendant with the short puts.

This is a short term speculation with an expiration date in just over a month. At the May expiration, either BBD.B shares will close above or below $1.50. If BBD.B shares are above $1.50, the puts will expire worthless and the calls will be exercised. At which point you deliver your BBD.B shares to the call buyer. Under this scenario the one-month return is 16.77% which occurs if BBD.B stays where it is, falls less than 12 cents per share, or rises.

If BBD.B shares close below $1.50 per share in May, the calls will expire worthless but you would be obligated to buy another 1,000 BBD.B shares at $1.50. Interestingly, the cost of the second block of shares is actually $1.50 per share less the 39 cent premium from the sale of the two options which results in a net cost for the second block of $1.11 per share. At this point the investor is holding 2,000 shares of BBD.B at an average cost of $1.365.

Either you earn a significant short term return or you end up with twice as many shares at a price significantly lower than Friday’s close. Which, by the way, is a real possibility and why this trade is best suited for aggressive traders.

What is a Reasonable Rate of Return?

There has been a lot of debate lately about the expected long term performance of equity markets. It comes down to a simple question; what is a reasonable rate of return? To paraphrase Bob Dylan, the numbers; they are a changing!

Ask most investors and they will tell you that double digit returns are possible, if not probable. And while that view may turn out to be correct it is certainly not supported by return data since the turn of the century.

For example, the iShares S&P/TSX 60 Index Fund (TMX, symbol XIU) has, on a price basis, returned approximately 0.791% per annum from its high in early September 2000. If you add back dividends the numbers are better with an approximate compound return of 3.15% over the same period.

With all due respect to the industry wide caveat that historical performance is not necessarily indicative of future performance, one cannot ignore long term trends if doing so results in unrealistic expectations. And the previous 16+ years of data comes nowhere close to investor expectations about future growth!

So… what’s reasonable?

Reasonable assessments begin with an assessment of the economy in terms of its potential and pitfalls. Because the Canadian economy is influenced by exports to the US the potential and pitfalls are one in the same. The performance of the US economy goes to our benefit and detriment. And while the US economy may be the best house on a bad street, it is certainly not a pretty picture.

I am not suggesting the Canadian economy is bed ridden. Quite the opposite as the numbers are pointing to stronger growth. However we cannot escape the fact that we operate between a rock (central bank largesse) and a hard place (a tepid global recovery). The implication is tepid growth for Canadian GDP likely between 1.0% to 2.0% rather than the 2.5% to 3.5% range that approximates historical norms.

The objective is to build an investment thesis that mimics toned down growth expectations. To that point investors might want to re-think the role dividends play in a portfolios’ total return. I suspect dividends will become ever more important in terms of total return. And if you believe as I do, that a more realistic return assessment is somewhere in the mid-single digits, then mature blue chip dividend paying stocks should anchor the portfolio.

If we add option writing to this discussion the combination of dividends and premium income should deliver returns in the mid-single digits while at the same time reducing portfolio risk.

Case in point is the Enbridge Income Fund Holdings Inc.* (TMX, symbol EMF, Friday’s close $29.49). EMF operates pipelines on behalf of Enbridge Inc. (TMX; symbol ENB) who owns 50% of the fund. Think of EMF as a toll road for oil and natural gas. The fund distributes monthly income to unitholders based on the tariffs to transport gas through the pipeline. It currently pays 15.6 cents per unit per month which equates to a 6.33% yield that we believe is sustainable.

EMF also has options. The EMF October 30 calls are trading around $1.10. If you write the October 30 calls at $1.10 the six month return if exercised is 5.4%. Add back six monthly distributions and the return pops to 8.6%. Return if unchanged is 3.72%, ex-distributions, and 6.9% including distributions. Downside breakeven taking into account the dividends is $27.46.

In this case we have an example of a company where there is a high probability of ending up with a return in the mid-single digits without requiring a larger than life upside move.

In my view… a reasonable rate of return!

* Full disclosure, clients of Croft Financial Group own positions in the Enbridge Income Fund.

Has the Tide Turned for the Canadian Economy?

The last two months have dynamically changed the narrative toward the Canadian economy. Over those two months, the markets have substantially shifted, including:

  • 15% rise in the Canadian Dollar from its $0.68 lows to its current levels around $0.78.
  • 27% rise in oil prices from their lows below $30.00 to around $38.00 today.
  • 16% rise in the TSX60 from its 680.00 lows in January to its current levels at 790.00
  • 36% rise in the Canadian Energy stocks based on the iShares S&P/TSX Capped Energy ETF (XEG).
  • Canadian GDP numbers for January came in at 0.6%, double the 0.3% forecast.
  • Canadian Real Estate in Vancouver and Toronto continue to accelerate with strong demand at record levels.
  • The Federal stimulus package is expected to give the Canadian economy a boost and diversify the economy away from being commodity centric.

So everything is ok, right? Thumbs up, time to go long Canada, EH!

The picture may not be so rosy when this is all put into context.  Let’s tackle the bullish points one at a time.

First off, the Canadian dollar rally has to be put into context of the prior decline. The decline in 2015 was one of the single most significant and steep declines in the Canadian dollar since the 2008 financial crisis.  After such extremely oversold conditions, the current rally is just modestly retracing the prior weakness.

Similarly, when looking at oil, after a decline from $120 down to under $30, this rally can categorize as proportionally underwhelming.  Even a 50% retracement of the 2015 decline should have seen oil rise to above $50.00 a barrel.  If broader weakness persists, further pressure will continue on many of the mid-tier oil producers as many companies are burning heavy cash flows at current levels.

Much of the rise the Canadian stock markets was driven by a broad rebound in commodity stocks and financial banks.  There are plenty of risks that this may be short lived.  There remains a global economic slowdown that will keep the rise in commodities in check.  At the same time, the global banking sector remains heavily challenged in Europe, China and increasing in the U.S.  In that light, Canadian banks still disproportionately rely on energy financing and real estate for their revenues. While both energy and real estate are stable for now, where is the future growth engine going to emerge?

In regards to the economy, the January GDP numbers had a big boost from the weak dollar, which now has rebounded. Will the strengthening dollar weaken future numbers?  Obviously many turn to the Federal stimulus package as a further driver of growth, but many experts are skeptical suggesting that the federal budget could still fall short of delivering a meaningful pick-up in growth.

From our perspective, there are plenty of reasons to still consider hedging some of the risks.  Utilizing option overlay strategies such as protective puts, collars and index option hedging are all very attractive, particularly during this period where the implied volatility in the markets has declined making it more affordable to implement.

Generating Income With a Limited Risk

Selling or writing options can be a great way to generate cash flow as a compliment to a diversified investment approach.  In general, the strategy involves selling a call or a put and getting paid to take on the obligation to either deliver or purchase the underlying shares at the strike price agreed upon.  The objective of the option writer is to keep the premium as the written contracts expire out of the money.  If an investor believes a stock is going to stay relatively the same or drop in value, a call my be written.  If the investor believes the stock is going to stay relatively the same or go up in value, a put may be written.  Implementing this approach in the absence of holding a position in the underlying stock is refereed to as being “naked”.

For more detailed information refer to the following equity option  strategy guides:

The challenge for many investors when considering this strategy is that there is an undefined risk exposure if the shares trade beyond the written strikes.  Because of this, the broker will require the option writer to put up sufficient margin to maintain the position.  This can also be a challenge for investors with smaller accounts.
One consideration is to implement a Credit Spread to limit the risk and reduce the margin requirement.
The primary objective of the Credit Spread is to collect a premium from selling a contract expected to expire worthless, not unlike the naked option writer.  The key difference is the simultaneous purchase of a less expensive contract using a portion of the premium collected.  While this second “leg” reduces the overall credit collected, the investor has limited the risk exposure of the the position to the difference between the two strike prices less the net premium collected.
For a general overview of the bullish and bearish Credit Spreads check out the links below:
Let’s take a look at an example using Cameco Corportion (TSX:CCO).  When considering any option writing strategy, I like to look at the price chart to identify support and resistance levels.  If the share price is approaching a resistance level, the consideration is to write calls with the expectation that the move higher is likely to stall and pullback for a period of time.  If the share price is approaching a support level, the consideration is to write puts with the expectation that the move lower is likely to stall and bounce.
Based on the chart of Cameco below, it appears as though the share price is at a resistance level and that a short term pull back is likely.
CAMECO (TSE:CCO) Daily, March 23, 2016
If we expect that shares of Cameco are likely to be trading below $17.00 between now and April 15th, 2016 (options expiration)  A Bear Call Credit Spread could be constructed as follows:
Sell April expiration 17 strike call = $0.50 per share credit
Buy April expiration 18 strike call = $0.20 per share debit
Net credit = $0.30 per share
Max Risk = $0.70 per share ($1.00 spread between strikes less $0.30 credit)
Our maximum loss would be realized if the shares are trading above $17.30 on expiration.
To look at it more practically, an investor could sell 10 credit spreads and collect $300.00 for a maximum risk of $700.00.  This represents a 42% return on risk for holding the position for 22 days (present date to April 15 expiration)
Lets’ consider a $100,000.00 portfolio
Granted the credit received will differ from spread to spread,  Let’s assume this strategy is implemented successfully on a monthly basis. Based on that assumption, approximately $3600.00 in cash flow could be added to the portfolio representing about 3.6%.  That said, each time the strategy is implemented the risk is limited to the spread less the credit.  In this example, $0.70 times the 100 multiplier is $700.00 or less than 1% of the over portfolio value.  The overall risk is that the investor is consistently wrong about their expectation and losses add up.
To conclude, this strategy can be a relatively passive way to increase cash flow in a non-registered portfolio beyond the traditional means. The investor can switch between the Bear Call Credit Spread and Bull Put Credit Spread depending on their outlook on the individual stock and overall market.  The probability of the spread expiring profitably can be adjusted higher by selling further out of the money spreads.  That considered, the trade off is the collection of less premium and the resulting increased risk.


Volatility represents the underlying stock price fluctuation, not the price trend. The degree of fluctuation can vary whether a stock’s price trend is bullish and advancing, bearish and declining, or remains in a steady range over time.

Historical volatility can be calculated based on a stock’s actual past trading history and reflects a range of closing prices over a given time period, usually one year. It can be measured as the annualized standard deviation on returns.

Implied volatility is that volatility measurement that produces an option’s actual market price as its theoretical value.

Implied volatility represents a market consensus on a stock’s future volatility. In other words, it is the expected volatility of the underlying stock implied by the marketplace as it currently values an overlying option. And because it is a collective effect of the numbers and opinions of all buyers and sellers in the marketplace, implied volatility can change often during the lifetime of an option.

As implied volatility increases, call and put prices also increase, and as it falls, they fall as well. Implied volatility is dynamic. It can increase or decrease during an option’s lifetime and lead to unexpected profit or loss.

When you’re considering the purchase or sale of an option today, you’re as much concerned with where the underlying stock will or could be trading in the future. Volatility assumption is by nature subjective. If you have an estimation about an underlying stock’s future volatility level, you can use this measure in an option pricing model, such as the well-known Black-Scholes model, to compare its current market price to its theoretical value. Any difference between the two will be your relative gauge of how overpriced or underpriced that option may be.

To determine an option’s implied volatility, you can use MX options pricing calculator.

Change in the actual, observed volatility of the underlying stock may or may not result in changing option prices, depending on the marketplace’s response.

A change in implied volatility, on the other hand, by definition, results in changing option prices, impacting the profitability of your positions.

Assessing values and choosing strategies

If implied volatility levels are lower than usual—that is, the options appear relatively undervalued—investors might choose strategies that involve long options positions. For instance, if they’re bullish on an underlying stock, they may buy calls.

On the other hand, if volatility levels seem to be high at the time, and the options seem overvalued, investors might choose strategies that use short options. If they’re still bullish on the stock, they may choose to sell cash-secured puts or covered calls.

For further details on the strategies mentioned, please visit our section Guides and strategies under the Education tab, at

Buying options that are undervalued or selling those that are overvalued because of current implied volatility level by no means guarantees profits. For long option positions before expiration, increasing implied volatility has a positive effect on potential profits. For short positions, decreasing volatility has a positive effect.

Trading implied volatility means focusing primarily on a favourable change in an option’s volatility level to achieve a profit. So when you establish an option’s position, you want to understand what you’re really relying on more for profit—sustained up or down movement in the underlying stock price or fluctuating implied volatility levels.

Changing implied volatility level might be considered a market within the market. It can present a picture of the marketplace’s collective forecast of the risk that an underlying stock will trade in a wider range in the future.

If your focus is to trade volatility as many professionals do, you should follow the option market closely and be familiar with current and historical implied volatility levels for any underlying stock and its options.

Will Gold Glitter Again - Part II

With gold having a strong start to the year and a solid 20% off its 2015 lows, the bulls vs. bear’s arguments have taken center stage.  Let’s review both arguments.

Bear Case for Lower Gold

  1. Gold is an inflation hedge and performs poorly in deflationary times.  The most commonly referenced example is the 20-30% decline in gold prices during the 2008 financial crisis.
  2. Gold has very little real world purpose, mostly for jewelry.
  3. Gold is a barbaric relic that has lost its role as world money.

The current arguments against gold are best illustrated by Goldman Sachs comments that this rally was an “overreaction” to the systemic risks from oil, China and negative interest rates.  Read the full comments.

The commercial hedgers in the futures markets echo those sentiments as they have been actively locking in the current gold prices with short futures contracts almost at 52 week highs.


When you put it into context, one can quickly develop a healthy amount of skepticism about the excitement of the best performing asset of 2016.  So what is the bull case?

Bull Case for Higher Gold

  1. Gold is not an inflation hedge, but a hedge on Central Banks and the Monetary System. The argument about gold’s decline during the 2008 crisis has to be put into the context that gold was coming off an all time high and in an overbought state, having risen over 100% in the prior two years.  That is structurally a different condition than today where gold has been stuck in a 4 year bear market decline.
  2. Gold is not only being held by central banks, but is actively being accumulated. If gold was a barbaric relic as many Keynesian’s would have you believe, it would have been actively distributed and abandoned by the banks.
  3. Gold has bullishly reversed the bear market downtrend. This is best illustrated by simply observing the 20 month moving average. The price of gold has remained in a bear market decline since January 2013.  The February 2016 monthly close, represents the first bullish close above that moving average.


The current argument can be illustrated by Deutsche Bank’s remarks that “gold is still expensive, but rising economic risks and market turmoil mean investors should buy it for insurance. click to read.

Looking Back

We have been here before; when back in October we made a case for gold mining stocks, not based on fundamentals but on sentiment.  Here is what we said:

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”.

Gold stocks have rallied close to 50% higher off their lows and 30% from the levels when we wrote the article.

How Can An Investor Participate While Managing Risk?

No matter how bullish an investor would like to be, one can recognize that off the existing price levels on gold and gold mining stocks, there is considerable downside risk if the investor is wrong and the stocks return back to 2015 lows.  How does someone participate while managing risk?

One can consider buying the underlying stocks and overlaying the position with a protective put.  As an example:

  • Investor buys 1000 shares of the iShares Gold Bullion ETF (TSX:CGL)
  • Investor invests $10,920.00 (trading at $10.92 per share)
  • Investor buys 10 put options to April at the $10.00 strike for $0.15 or $150.00

What has the investor done?

The investor has 100% of the upside of gold, no risk of being “noised” out of the investment with tight stop losses, or panicking out from day to day volatility.  Equally, if the bear case was proven to be correct and gold declines back to its 2015 lows, the investor is guaranteed to have their risk limited to $10.00 a share over the next 2 months.  This strategy is just one of many interesting ways investors can hedge and manage risk with options, when entering speculative positions in the markets.

Tales from a Reluctant Gold Bull

In an effort to provide full disclosure I am not now nor have I ever been a raging gold bull. I am not convinced that gold provides crisis insurance or any kind of hedge against economic Armageddon. Personally if the global economy collapses under the weight of a currency crisis (note: the collapse of paper currency is the latest fear mongering strategy intended to boost golds’ value), I would prefer to own a farm.

Having laid bare my biases a case can be made that a small amount of gold can play a useful role in a portfolio. My preference is gold mining companies because in a perverted way, mining stocks and I share a similar view. Preferring to sell gold at the margin rather than holding it as an insurance policy!

The appeal of gold stocks is that they are more volatile and tend to be non-correlated to other sectors of the economy. As such they can be an excellent diversifier within a portfolio if you are mindful of the risks. And there are many!

For starters trying to predict where gold prices are likely to go is like trying to forecast the path of an oncoming tornado. One would think given the global debt tsunami, zero to negative short term interest rates, instability among some of the worlds’ largest banks and mounting economic uncertainties that gold would shine. Yet until this year gold and gold stocks, as witnessed by the performance of iShares S&P/TSX Global Gold Index ETF (TMX: XGD, Friday’s close $11.12), have been in a five-year bear market. One could argue that, even with XGDs’ recent surge, the monthly charts have still not broken the longer term downtrend.

Still I have given up trying to pick bottoms. The best we can do is look for a reversal – which the performance in January seems to imply - and then examine the fundamentals. On the surface the fundamentals look decent. There appears to be a supply / demand deficit caused by a pickup in demand for jewelry mainly from India. Demand for Jewelry constitutes 55% of the 4,200 tonnes of global supply. Add to the mix, the aforementioned instability of some large European banks and negative interest rates most notably in Japan, and we have the makings of a melting pot that should support prices over the near term.

As for the risks, higher gold prices do not always translate into above average performance of the miners. Higher gold prices mean higher revenue but that can also be accompanied by higher costs. Not to mention, flooding, war, and labor unrest which can render mines useless for long periods of time. The point; when it comes to gold stocks… timing is everything!

The trick is to work with what the market is giving you. For gold stocks that is above average volatility which translates into above average option premiums. If you buy into the bull scenario for gold, writing covered calls on gold stocks can yield some decent results.

To make the point consider Goldcorp (TMX: G) which closed on Friday at $21.25. The Goldcorp April 22 calls closed Friday at $1.55. If you buy the shares and write the April 22 calls, the 53-day return, if exercised, is 10.8%.

Agnico Eagle (TMX: AEM) is another example. AEM closed Friday at $47.62 and the AEM April 48 calls were trading around $3.40. That translates into a 53-day return, if exercised, of 7.9%.

If you are looking for a more aggressive position take a look at Franco Nevada (TMX: FNV, Friday’s close $78.75). The company has issued purchase warrants (TMX: FNV.WT) that can be used to cover the sale of a call option.

The FNV purchase warrants expire on June 16th, 2017 and have a strike price of $75 per share which means they are $3.75 in-the-money. The long dated nature of the warrants will cause their time value to erode at a much slower pace than will occur for the near term at-the-money or slightly out-of-the-money calls. The FNV warrants closed Friday at $14.00 per share.

You could buy the FNV warrants and sell, say, the FNV March 80 calls at $3.30. If the calls expire worthless over the next 25 days, your return will approximate 23.6% depending of course on the value of the warrants at the March expiration.

Think of this trade as you would a time or calendar spread. The idea is to continue writing short term (i.e. one month) at-the-money or slightly out-of-the-money calls covered by the FNV warrants. As the calls expire you are effectively reducing the cost of your long warrants. However, this is a more aggressive trade which will require you to monitor it on a daily basis.