Weekly Options Now Available in Canada

I had the pleasure of presenting at the Toronto Options Education Day back on September 27th, 2014.  The topic was “A Guide To Weekly Options”.  Even though the contracts had yet to launch the interest was overwhelming and many traders and investors have been patiently waiting to access this new product since then.

Well the wait is over, the Montreal Exchange has officially launched weekly options on the following stocks:

  • Barrick Gold Corporation (ABX)
  • Blackberry Ltd (BB)
  • Encana Corp (ECA)
  • Goldcorp Inc (G)
  • Ishares S&P/TSX 60 index ETF (XIU)
  • Potash Corp of Saskatchewan (POT)
  • Royal Bank of Canada (RY)
  • Suncor Energy Inc (SU)
  • Toronto Dominion Bank (TD)
  • Yamana Gold (YRI)
These options have the same contract specifications as a standardized monthly contract except that they are introduced on a Thursday and trade through to the close of the Friday of the following week. The main difference between Canadian weekly options and U.S. Weeklies is that only 1 Canadian weekly can be listed at any time unlike U.S. Weeklies which allow up to 5.
With this in mind, Canadian weekly options offer traders and investors a new approach to meeting their objectives.

Benefits include:
  • More choice for spreads and combinations
  • Cheaper premiums for greater short term leverage
  • More sensitivity to stock price movements for short term traders
  • Target specific events without having to purchase more time than needed
  • Protect positions against earnings by purchasing 1 week of protection versus one month
  • Enhanced cash flow for option writers with 52 expiration dates per year
Challenges may include:
  • Requirement of active management based on short term objectives
  • Little time to make adjustments due to accelerated rate of time depreciation
  • Less up front premium for the option writer
  • May be more commission intensive
Individual traders and investors will have to determine for themselves how, if at all, weekly options will fit into their plan.  I am not personally a “short term” options trader however I see significant opportunity in using these weekly options as part of an income strategy.
Income Generation
Using weekly options as part of a Covered Call strategy presents an opportunity to take advantage of the rapid time depreciation associated with a short term option contract.  This also allows the investor to evaluate expectations on the stocks performance over a short period of time and make adjustments accordingly.
Below is an example of Barrick Gold Corporation (TSE:ABX).  The important consideration is to compare the annualized rate of return for each option write.

Barrick Gold Corporation (TSE:ABX) shares at $13.21, 14 strike call write:
ABX Weekly Comparison

Observations
While the longer term option writes deliver greater up front premium and are less transactional, the annualized rate of return is lower than the weekly write.  With that in mind, the weekly option provides enhanced cash flow over the long term but offers less upfront premium.  In a primary bullish market, this may be a good trade off. However, if there is an expectation that the market may be volatile (to the down side) collecting more premium up front to mitigate the anticipated market volatility may be the best solution.

The bottom line is that weekly options have unique characteristics that make them a viable solution in certain situations.  It is up to the investor to determine where they fit into their plan.  I believe the more tools we have at our disposal, the more effective we can be as retail investors in navigating these markets. For more information on weekly options available on Canadian stocks visit MX Products>Weekly Options

Using Stock Cycles For Covered Call Writing

As a Chartered Market Technician I spend considerable time exploring the quantitative side of stock and broader market cycles to find periods of statistical advantage. For investors it is often simply trying to maximize the returns from a longer term holding. I have found that there is considerable value in enhancing investment yields through periodically and passively implementing covered calls.

Key tenants to this methodology are the open acceptance that stocks do not just go up in a straight line, but rather go through cycles of overbought and oversold conditions. If that can be openly accepted, then it becomes about identifying a measuring technique to quantify that cycle.

To illustrate, I will use BCE shares. BCE has been in a decisive bull market from its 2008 low of $16.85 to its current test of multi-year highs. A disciplined and patient investor has been well rewarded with a material capital gain and a consistently lucrative dividend income stream. But when one looks deeper into the cycles, investors may see value to seeking to enhance that return.

On the table below I simply identified where the stock price was relative to its 52 week mean average. What is identified is that over the last 5 years BCE has had 7 intermediate swing highs that, on average, occurred when BCE was trading $5.00 above its 52 week mean price. Each of these 7 periods the stock proceeded to consolidate lower or sideways an average of 185 days (6 months).

If an investor was to believe that there is statistical merit to that observation, then selling covered calls on the stock when it has reached an overextend state would enhance the yield income on a stock with limited short term upside potential.

Last week on November 21st, BCE had a closing price at $54.24, which was $5.96 above its $48.28 52 week mean price. Referencing the 7 past cycles, this suggests that BCE may be close to the upside of its current rise and there may be increasing value in writing a covered call at these levels.

  • At the time of writing (Nov 26, 2014), BCE is trading at $52.88
  • May $54.00 covered call is bidding $1.05 (1.99% cash flow)
  • May $56.00 covered call is bidding $0.50 (0.95% cash flow)

For an investor that owns BCE for the current 4.67% dividend income stream, selling a strategic covered call gives the potential to enhance that income to 5.50-6.50%. While there is no guarantee the stock cannot go higher and exceed the call strikes, an investor that looks at the probability associated with the rise may recognize it is far more probable that the stock consolidates after such a substantial rise. If a covered call was strategically written at each of these 7 prior peaks, the investor could have collected 5-15% addition income over the last 5 years.

Using options is an active strategy, that may involve having to sell the stock or buy back the option which makes the strategy more dynamic. But for an investor willing to be more active, the additional income may be worth the effort.

A Year End Rally?

We have a short week of trading in light of US thanksgiving. Just enough time to position your portfolio for a year-end rally?

A year-end pop seems to be the consensus opinion among the largest US hedge funds. Mind you that may be hype or at a minimum wishful thinking. Fact is many large hedge funds have under performed a passive and much less costly investment in the S&P 500 composite index. They will need a year-end rally in order to justify their fees.

While I tend to discount the blather that comes from the hedge fund community I think this time they may be right. Consider the macro picture; the decline in the price of oil has given US consumers a massive tax cut coming into Black Friday. If history is any guide that should lead to a boost in spending. With two thirds of US GDP dependent on consumer spending that may well push year over year US GDP above 3%.

If you buy into the premise of a strengthening US economy, Canadian investors must be aware of the impact on currencies. If oil prices continue to decline and if the European Central Bank and Japan central bank resume their quantitative easing programs, the US dollar will rally into the new year. Now Canada will be hedged somewhat as we will ride the coat tails of the stronger US economy. But the decline in oil prices will prevent any rally in the Canadian dollar. At best the loonie will track the US dollar although it is more likely that it will decline slightly in the months ahead.

The easiest way to play this US story is to buy a non-hedged S&P 500 ETF. The Vanguard S&P 500 ETF (TSX: VFV) comes to mind.

Another consideration for Canadian investors is how this playbook will impact commodity prices; particularly gold. A higher US dollar would slow any rise in gold and gold stocks especially if there is little evidence of inflation.

My trade here is to execute a bear call spread on a Canadian gold stock such as Goldcorp (TSX: G). Goldcorp recently traded at $23.20. Look at writing the Goldcorp December 24 calls around 70 cents while buying the Goldcorp December 27 calls at 15 cents. This will produce 55 cents net credit which if I am right should expire worthless at the December expiration.

Options Combinations to Reduce Risk

One of the true benefits of understanding the complexities of the options market is the ability to construct strategies that help meet any number of trading and investment objectives. Often times novice option enthusiasts are intimidated by multi-leg combinations because of the number of “moving parts”.  For those of you that are not sure what I mean by “multi-leg” this term simply refers to a strategy that is constructed of the purchase and or sale of different option contracts.

In order to understand any multi-leg strategy, we first need to have a solid grasp of the rights and obligations associated with being an option buyer versus an option writer.  There are a number of videos at M-X.TV that can help you with this; however a review of the Introduction to Options trading video should cover all the details necessary.

For the purpose of this blog post, I want to look at constructing a 4-legged strategy known as a Directional Condor.  It is important to realize that any complex strategy is simply a combination of multiple “simpler” strategies. By dissecting the components, the novice option trader can begin understand why a certain advanced combination may be appropriate.  In addition, by understanding the rights and obligations associated with the various components any limitations to the strategy can be identified and the trader can manage performance expectations accordingly.

A Directional Condor may be applied when the trader has an expectation that a stock is going to move in a particular direction, but is not likely to exceed a certain price range within a specified period of time. The Directional Condor is simply a combination of a Debit Spread and a Credit Spread.  Check out these videos for a more detailed description of the strategies and examples of how they may be applied independent of one another.  Bullish Spread Strategies and Bearish Spread Strategies and further to these, Defining Option Spreads

The Debit Spread is used to trade the directional bias.  The trader incurs a cost but may want to further offset this cost.  By selling a Credit Spread further out of the money, but with the same expiration date, a credit is received and the net cost of the position is reduced.  This lowers the break-even point of the trade and increases the percentage rate of return should the investor be correct in their forecast.  The “trade-off” is that in order to achieve maximum profitability, the stock needs to be trading between the written strikes of the Debit Spread and the Credit Spread on expiration.

Take a look at the daily chart on Blackberry Lmt (TSE:BB) below as an example:

bb conder

4 Legs, 2 Strategies

As I mentioned, the more complex strategy is simply a combination of two, less complex strategies.  By breaking it down this way, it becomes easier to understand the logistics if the trade, and more importantly how to execute it within you brokerage platform.

condor

For the purpose of this example, we will use options expiring in January 2015.  As of November 12th, 2014 the prices of the option contracts were as follows

January, 13 strike Call -  $1.10 Buy
January, 14 strike Call -  $0.70 Sell
January, 15 strike Call -  $0.50 Sell
January, 16 strike Call -  $0.30 Buy

The net cost of the Condor is $0.20/per share.  This represents the maximum risk of the trade regardless of what happens with the stock.

The Maximum profit is the difference between the 13 and 14 strikes which is $1.00 minus the cost of the trade which is $0.20.  This results in a profit potential of $0.80.

There are 2 break even points on expiration because of the combination of Debit and Credit Spreads
Break even #1 is the 13 strike purchased plus the cost which equals $13.20
Break even #2 is the 16 strike purchased minus the cost which equals $15.80

Maximum profit is achieved when the stock is trading between $14.00 and $15.00 on expiration.  This would represent a 400% return on risk.  Remember that you can close the position in its entirety or “Leg Out” which means off set a portion of the combination at any point before expiration to lock in profits or manage risk.

While the Condor has a limited profit potential, the multi-legged combination offers a very attractive risk/reward opportunity if the trader feels that the stock is not likely to trade beyond a certain range within a specified time frame.

Irrefutable Testament To The Value of Put Protection

First off I wanted to say thank you to all the Toronto Options Education Day attendees for a warm welcome, it was a pleasure to meet all of you.  Recently the stock markets have increasingly become volatile as almost all Canadian sectors have gone through a healthy profit taking cycle.  This gives us the opportunity to reference back to our prior blogs where we demonstrated the use of puts as protection.

For those who are new to put options - every 1 put option purchased on a stock represents a contractual right to be able to sell 100 shares of a stock at a specific price over a specific period of time.  When used as protection for investors owning stocks, it offers the ability to create certainties in an ambiguous market.

Looking back to August 29th.  I wrote a blog titled “Is there any Fuel Left in the Energy Sector Bull Advance?” In that blog we referenced the substantial divergence between the price of crude oil (and natural gas) in relation to the material advance in energy stocks. I felt this created an increasing vulnerability to owning the shares and presented an example using Imperial Oil(TSX:IMO).

We could not have been more right.  The time of the blog marked the highest price Imperial Oil traded before a substantial decline of over 15% (close to $10.00 a share). In that example we purchased an October $56.00 put option (secured the guaranteed sale price of $56.00 for the shares).  I wanted to demonstrate the value the insured investor received vs. the traditional buy and hold investor.

Investor 1 - Buy and Hold

In this example the investor owned 1000 shares at an average cost of $45.00. At the time of the blog the stock closed at $57.50 which saw the investor up 28% in paper profits.  On October 17th the stock closed at $51.45 which saw the investor lose half the profit down to 14%.

Investor 2 - Bought the October $56.00 put as protection

In this example the investor owned 1000 shares at an average cost of $45.00.  The investor was also up 28% in paper profits on August 29th but that investor spent the $0.75 to buy the October $56.00 put protection.  On the October 17th options expiration the put option was $4.55 in-the-money ($56.00-$51.45).  This allowed the investor to close the put at a net $3.80 gain ($4.55 - $0.75 cost).  The gain on the put allows the investor to have a new adjusted average cost on the shares of $41.20 ($45.00 - $3.80).  This means that at the $51.45 closing price and a $41.20 new average cost, the investor is still up 25% on the stock, in spite of a violent $10.00 decline from top to bottom in the 2 months of the trade.

The key take away is the investor protected themselves, managed risk, locked in gains and substantially reduced the volatility of their portfolio.  Who says options are risky now?

In my opinion, investors taking the time to educate themselves on options as an investment tool is one the single most important things one can do to improve the chances of long term success.

Cheap Isn’t Always Better

I’ll be traveling to Winnipeg today on behalf of the Exchange to facilitate a workshop for aspiring, active investors.  I have had the opportunity to present to this group on several occasions and despite the anticipated cold weather, I know the crowd is always warm, very interactive and hungry to learn.

That said, one of the topics I will be focusing on will be options trading mistakes to avoid. I always think that this is a great topic, because regardless of how well you understand the basic trading principles of using options, it’s good to be reminded of some of the pitfalls that stand between you and trading and investing with options successfully.

While there are many common mistakes (I cover 10 in my presentation) I want to focus on one that proved to be an expensive misunderstanding for me when I first started options trading. In fact, if you are interested in the entire breakdown of the the most common mistakes, check out this video found at M-X.TV
Avoid The 10 Most Common Option Trading Mistakes

The Misconception

There tends to be a misconception that buying cheap options is the best way to leverage capital and a surefire way to guarantee a home run on a stock that is expected to make a substantial move.

While it is true that options offer a trader the ability to substantially leverage their capital with a limited and identifiable risk, it is important to understand that options are cheap for a reason. Often time’s novice traders overestimate their probabilities of being correct and underestimate their risk.

It’s all about the probabilities

I am going to assume that readers already have a basic understanding of terms such as strike price and expiration date as they relate to the options market.  If not, here is a link to an Introduction To Option Trading video.

In order to truly understand the importance of probabilities, aspiring option traders must recognize that options are priced based on the expectation of whether a stock has the potential to trade beyond the selected options strike price within a specified time frame.

For example, let’s take a look at call options on Blackberry Limited (TSX:BB) Currently the shares are trading at $11.70.

To look at it from the perspective of time:

Note that the more time allocated for the stock to move towards and beyond $12.00, the more expensive the option contract. This is because the market is pricing in the stock’s average Historical Volatility.

Historical Volatility is the amount that a stocks share price has been fluctuating over a period of time.  For more information on volatility check out out Patrick’s blog Trading Volatility. The price of the November contract is suggesting that there is a moderate chance that shares of BB are going to trade above $12.00 by the November expiration based on its historical trading behavior.  Not a good bet in my books.  By allocating more time, the trader has a higher probability of being correct. Remember, if the move happens in a day, you can still close your longer term option out for a profit. However if the move happens over a 3 month period, the November option will be long expired and a full loss potentially realized.

Because we are focused on trading shorter term price movements on volatile stocks, we tend to focus on selecting 2-3 months out for our expiration dates. This is with the expectation that we are likely going to be out of the position within 1 or 2 weeks.  Despite the fact that we have a shorter term outlook, we realize that our anticipated price move may not happen immediately.  By allocating more time than anticipated we believe we are “erring on the side of caution”

You also don’t want to purchase too much time either.  As a general rule, slower moving stocks need to be given more time for the price to reach the anticipated level.  You also must consider whether you are an active trader with a short term outlook or whether you are more passive and have a longer outlook.

Rule of thumb

Know the stock you are trading options on, determine your outlook, select the appropriate time frame and manage the position accordingly.  And when in doubt GIVE YOURSELF A LITTLE MORE TIME!

As for my lesson

I did all of the research, analyzed the price chart and was confident the stock was going to move.  I wanted to get the best bang for my buck so I chose a cheap, short term option.  Long story short…I was right about the stock but wrong about the time I selected for my option contract.  1 month passed, my option expired worthless and then the stock took off as anticipated. In hindsight, I could have purchased fewer contracts but with more time. This would have tipped the probabilities of being correct more in my favor and allowed me to profit from my original outlook.

Remember, learning to trade and invest with options is an ongoing journey and we learn from our mistakes. Be sure to analyze your losses to see if you took all things into consideration.  We are dealing in a business of probabilities, so if we can filter out mistakes such as the one discussed here, we tip the odds a little more in our favor.

Options Education Day 2014 - Toronto Final Presentation

Trading Volatility

It is common for traders that are new to options to make many of their trading decisions based solely on the prediction of the price move. While the price move is an important component of the overall success, the ultimate profitability is dramatically impacted by volatility pricing.

Implied volatility is materially different than the stock’s historical volatility. The historical volatility is a reflection of the stock’s actual past range. On the other hand, the implied volatility is far more a gauge on the sentiment of investors.

Why?

In the options market, there needs to be a buyer for every seller. It is a zero sum game. Suppose there is a considerable demand from option buyers to accumulate calls on a hot stock. If the demand is skewed, the implied volatility would need to steadily increase until it incentivizes the sellers of the options enough to reach an equilibrium. This is a process of price discovery in the live markets.

What does this mean for traders and investors?

It means that almost all known information or consensus expectations on a price move are often fully accounted for in the option price. Taking that into account, how does a trader create consistency in profits?

Well this is a question we will seek to answer in detail during the Toronto Options Education Day on Saturday, September 27th, 2014 at the Metro Convention Center. In Package 2, I will spend the morning going into detail on understand volatility.

9:00 a.m. to 12:00 p.m. – Vega: Friend or Foe? – MX instructor Patrick Ceresna
(Break from 10:15 a.m. to 10:45 a.m.)

Volatility seems to be a recurring theme that many options traders struggle to fully understand. It is a crucial component in the pricing of an option contract and it is extremely important that investors learn to fully utilize it. Join Patrick to be equipped with all the essential knowledge to not only hedge against volatility risk but also to trade volatility! This workshop provides an introduction to volatility strategies and explains how Vega, the measurement of sensitivity to volatility, can either work for or against the investor. Strategies covered will include straddles, strangles as well as the effect of volatility on debit and credit spreads!

There are a few seats still available, if you are interested, please register using the following link. http://www.m-x.ca/evenements/optionsdayTor14_en

I look forward to meeting you at the show.

Patrick Ceresna’s OED Presentation

Is there any Fuel left in the Energy Sector Bull Advance?

Canadian energy stocks have been bulling higher for most of the year.  The iShares S&P/TSX Capped Energy ETF is up 18.68% year-to-date (as of Aug 28). This renewed strength in the energy stocks has been a major contributor to the robust bull market advance in the broader Canadian indices.

Can the energy stocks keep rising?

While there are a number of fundamental input variables and broader market conditions that must be taken into consideration, there is one underlying divergence that continues to raise red flags.  This is the divergence between the underlying stock prices and the price of crude oil and natural gas.

The Divergence

January 2014 low of WTI crude oil was $86.00.  Between January to June, crude oil prices have risen to a high near $105.00 (on the October contract) or a $19.00 rise.  During that advance, the iShares S&P/TSX Capped Energy ETF has rallied from $17.00 per share to a high near $21.50.  Since the June highs in crude, we have seen a steep decline of over $12.00 a barrel, bringing prices just a few dollars from the start of the year.  At the same time many energy stocks have not reacted.  As an example, Imperial Oil (TSX:IMO) is at $57.50 and trading at its 52 week high, Canadian Natural Resources (TSX:CNQ) is at $46.67 and just a few dollars from its 52 week highs, Suncor (TSX:SU) is at $44.14 and also just a few dollars from its highs.

The question to ask - Can the Energy stocks hold their robust gains and advance higher when the underlying commodity prices declining?

At minimum, we can conclude that the divergence does create short-term risk in fundamentally good stocks that can be owned for the long-term.  With the current low implied volatility, buying short-term protective puts becomes an increasingly beneficial proposition.

As an example, an investor that has held shares of Imperial Oil throughout the year has participated in a $12.00+ advance from $45.00 at the start of the year to the $57.50 current highs. In consideration of the paper profits made, the investor can buy the October $56.00 put for $0.75 (as of August 28th).  For a modest cost, the investor can create a unique scenario where:

  • The investor is guaranteed a $56.00 sale price if the stock drops in reaction to deteriorating oil prices.
  • If oil prices were to bottom and begin advancing, the investor remains long the stock and continues to participate on all further gains.

In light of gains made and the divergence in crude oil prices, protecting the profits made over the short term may have some appeal to some investors.