Probably the most noteworthy event in the first half of 2015 was the surprise rate cut issued by the Bank of Canada (BoC) in the first quarter. It was designed to provide “insurance against a downturn” in light of the sharp decline in oil prices.
The BoC was right to be concerned. Unfortunately policymakers underestimated the impact lower oil prices would have on the Canadian economy. GDP was negative for the first half of the year and is closing in on recession territory.
Most of that weakness was the result of an abrupt decline in business investment particularly within the energy and commodity sectors. Precious metals, base metals and textiles are all down on the quarter which economists attribute to slowing global demand and a strong US dollar. The latter point is particularly relevant as there is typically a high correlation between commodities and the greenback.
The challenge for many investors is syncing the positive employment numbers (unemployment holding steady at 6.8%) and inflation data which is within the BoCs’ 2.0% target. However when you take away the volatile food and energy components, core inflation is closer to 0.9%.
Unfortunately both of these metrics are lagging indicators. It is only be a matter of time before the effects of an economy moving away from its potential shows up in this data series. That is unless there is a change in business conditions or some kind of intervention by the BoC.
Like others I was of the opinion that Canadian manufacturing would pick up due to lower oil prices softening the impact lower energy prices would have of the economy. That has not played out as expected for reasons that have longer term implications.
The US has been gradually shifting more of their business to Mexico. While a stronger USD makes Canadian goods more competitive, those same forces are amplified when applied to the decline in the Peso. Couple that with lower labor costs and Mexican exports are simply more competitive.
To put some meat on this skeleton Canada’s share of US imports from North America has fallen from 75% in the 1990’s to 50% this year. The end result is that Canadian exporters will benefit from a weaker loonie and a strengthening US economy but its’ impact will be less than in previous expansions. So despite the view that a rising tide lifts all boats it looks like Canada will be getting a smaller piece of a bigger pie.
With respect to interest rates the BoC like their counterparts in the US, have stated that any decisions on interest rates will data dependent. Considering weak GDP data, lackluster business outlook, low inflation and weak manufacturing data one could surmise that another rate cut may be in the offing. Perhaps sooner than later.
One way to play Canada is to look in the consumer staples sector and search for companies that have a domestic focus. One that comes to mind is Alimentation Couche-Tard Inc. (TSX: ATD.B, recent price $58.00). This company operates a chain of convenience stores most of which are located in Quebec. Buying the ATD.B Feb 58 calls at $4.25 look interesting for aggressive traders.
I apologize for the title but I couldn’t resist. Valeant Pharmaceuticals International (TSE:VRX) continues to defy broader market complacency. The diversified pharmaceutical company has barely wavered in its price advance since August of 2014. While this trend may be getting a little long in the tooth, the question is whether there is a little more upside momentum to capitalize on. As of the close today (July 15, 2015) the shares have breached a historical high, closing at $304.67. Check out the chart below:
Now, if you think this stock is out of your price range, you may want to read on. I chose TSE:VRX to demonstrate how options can be used to take advantage of an expensive stock at a significantly reduced price. Let’s assume that we believe that the share price of Valeant (TSE:VRX) is likely going to re-test the previous high of $310.00 or perhaps higher over the next month. With the shares trading at $304.67 we may want to consider using a call option expiring in August with a strike price of $305.00. The last price for this option was $13.00 per contract. What an investor may want to take into consideration is that the short term target sits at $310.00. If the last price of the option contract ($13.00) is added to the strike price ($305.00), the break-even on expiration is determined to be $318.00. If the move happens quickly, it is possible for the long call position to be profitable. However, if the stock takes its time, or takes a detour, the probability of profiting is reduced. One way that we can lower our break-even point is by creating a Bull Call Debit Spread. This will lower the net cost of the trade and as a result, the break-even point.
The trade could set up as follows:
Buy 1 - August 305 Call $13.00
Sell 1 - August 310 Call $10.40
Net debit = $2.60
What we have effectively done is reduced the cost of participation even further by selling the out-of-the-money call and collecting the premium. While this limits the upside potential, the break-even point is now lowered to $307.60 which is determined by adding the newly adjusted cost of the trade to the 305 strike call.
In addition, the risk exposure has been reduced from $13.00 per share down to $2.60 per share. While the strategy has a limited upside, the investor has the potential to generate a 92% return on their risk should the shares be trading at or above $310.00 which is the strike of the written option contract.
This strategy is also an effective way to lock in profits on shares owned while continuing to participate in the stocks upside. Investors are often hesitant to sell their shares for a profit for fear that they may miss out on further upside potential. One solution is to sell the shares at a profit and replace stock ownership with the right to own the shares through the purchase of a call option or a Bull Call Spread.
The benefit of this is three fold:
-Investor locks in profits on shares owned
-Investor frees up capital to take advantage of new opportunities
-Investor may continue to benefit from further share appreciation with a limited risk exposure
I should mention that TSE:VRX is set to release earnings on July 23rd. An earnings report can have a very significant impact on the valuation of the company. This may not necessarily be in the direction of the primary trend. With that in mind, an option, or spread combination is a great way to trade your bias with a limited and defined risk exposure, especially on an expensive stock.
For the first half of 2015 global financial markets have been obsessed with short term noise. We have witnessed a succession of exacerbated reactions to on again off again negotiations with Greece, waste of time debates on the timing of a Fed rate hike or endless dissections of monthly jobs data where 20% revisions are more the norm than the exception. If we can gleam anything from the first half it is the wide chasm that exists between the drivers of long and short term returns. That has not always been the case. In a normal economic environment, GDP growth, interest rates and job creation are considerations that impact both long and short term decisions. In a normal economic cycle – unfettered by central bank manipulation - analysts are able to dissect macro data and calculate its’ trickledown effect on earnings the single most important input into equity valuation. Regardless of Ones’ time horizon! In an environment where central banks are manipulating the business cycle and skewing earnings short term traders in particular, seek out alternative strategies. Note the six year outperformance of momentum stocks which excel in a low interest rate low volatility environment. Within this group valuations are propelled by new twists on old themes (i.e. Tesla) new concepts (i.e. Netflix), promising new drugs (see the entire biotech space). The problem is that a parabolic growth trajectory often leads to bubbles that have a tendency to burst under pressure from higher interest rates and increased volatility. That’s why macro events like Greece have an inordinate amount of short term influence on financial markets. When Greece settles down short term traders will turn their paranoia to the timing of the Fed’s rate hike. Not that any of this should affect long term returns but it will lead to periods of heightened volatility that will eventually be reflected in higher option premiums. So like it or not we have to pay attention. To that end let’s engage in a quick study of a Greek tragedy. What seems to be lost in the narrative is how a Greek exit would affect Germany. One could argue that Germany needs Greece more than Greece needs the Eurozone. The problem is selling that position to the German electorate. If Greece leaves there will be a period – maybe two to five years – where there will be upheaval. The Greek central bank will print Drachmas to support the economy. We may see an inflationary spike and certainly Greek exporters will be hurt. On the other hand excursions to the Greek isles will be a bargain and in time the Greek economy will settle and output will return to levels that existed prior to its inclusion in the Eurozone. It’s a much larger problem for Germany which is a country highly dependent on exports. For the German economy to continue its growth trajectory it needs access to a large free trade zone with a weaker currency. The Euro being a weak sister to the powerful Deutsche Mark (DM). If Germany was forced to trade in DMs – the end result of a Eurozone break up - it would have a dramatic effect on German manufacturers and exporters. The problem is that German politicians cannot sell this position to its citizenry. Which means that any deal must include some austerity measures that are seen as real concessions. Greece is playing the same game but from the other side of the fence. The July 5th referendum is a sub-plot. A high stakes poker game with Greek politicians encouraging a “No” vote to give them a “Grexit” chip to improve their bargaining position. The risk is that a “Yes” vote makes it more likely other members of the Eurozone will call their bluff. I think it is highly unlikely that Greece will exit the Eurozone. Negotiations will continue regardless of the referendum outcome, cooler heads will prevail, measured concessions will be offered by the Greeks and accepted by the Eurozone, and another potential fire will be doused. Just in time for short term traders to re-focus their attention on the Fed. What this means is that the second half may unfold in much the same way as the first half. Range bound equity markets that from time to time experience short term bursts of volatility. Momentum stocks will continue to outperform assuming volatility spikes quickly abate and any interest rate hike that occurs in September or December will likely be the only one we see until 2017 or later. In a range bound scenario with intermittent short term volatility spikes covered call writing should be the ideal strategy. The problem is that low volatility makes it difficult to find opportunities that could be classified as “no-brainers!” One approach is to keep some cash on the sidelines and look for volatility spikes. You will see that during market sell-offs which I think will be buying opportunities and ideal for implementing a covered call or short put strategy. Another line of attack is to look for sectors that share similar range bound metrics but with above average volatility. The oil and gas sector delivers these characteristics as I believe oil will most likely remain between US $40 and US $60 per barrel. To that end you might consider a medium term covered call on Canadian Natural Resources (CNQ, recent close: $33.85). In this example buy CNQ and write the CNQ November 34 calls at $2.40. The five month return if exercised is 7.53%, if unchanged 7.09% and downside protection is $31.45.
DEFINITION OF ‘COLLAR’ 1. The purchase of an out-of-the money put option is what protects the underlying shares from a large downward move and locks in the profit. The price paid to buy the put is lowered by amount of premium that is collect by selling the out of the money call. The ultimate goal of this position is that the underlying stock continues to rise until the written strike is reached. (investopedia.com) I wanted to dedicate this blog to exploring the choices investors have when managing an existing collar position after a stock has moved considerably lower. For this example, we have no better opportunity to debate the alternative choices, than using the Canadian Pacific collar example we published in our March 30th post. Click to read: http://optionmatters.ca/blog/2015/03/30/have-the-rail-stocks-been-derailed/ Back in March I was expressing my concerns about the impact the oil industry would have on the Canadian railway stocks and expressed concerns about the short-term risks in the stocks. In particular we focused on the Canadian Pacific Railway which at the time was trading at $229.24. Here is the trade that was opened: 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) Investor buys the October $230.00 put for $17.50 or $1750.00 debit for every 100 shares Investor then proceeds to sell an October $255.00 covered call for $7.50 or $750.00 credit for every 100 shares The net cost of the collar is $10.00 or $1000.00 for every 100 shares Currently, as we write this blog, Canadian Pacific Railway is trading at $198.00 (July 9th 2015). The investor has successfully secured the $230.00 sale price out to October. While the investors shares are over $30.00 lower in price, the net value of the options collar is $32.50 (the protective put is worth $33.00 and the covered call is valued at $0.50). With the stock and options combination having almost no time value remaining, the position is virtually delta neutral. Further to that, the protective puts delta is very close to -1, which means that almost all further downside risk that the stock may experience is entirely hedged. So what should our investor do? First off, the investor does not have to do anything immediately as the collar position was opened out to the October expiration. But it is worth discussing the choices the investor has if they felt compelled to act. In the first scenario, the investor feels that the Canadian economy will continue to struggle and that railway stocks are vulnerable to sustained weakness. If the investor simply would like to close the position, they can sell the stock and the options having hedged the drop beyond the cost of the collar. Alternatively, what if our investor was bullish and felt that this 20% decline in the stock from its highs was just an opportunity. Under that situation, the investor can position themselves to monetize the money made on the put protection to reduce the investors average cost base. When an investor elects to do this, they can always purchase a new, lower strike put as protection. Let’s demonstrate as an example: The CP shares are trading at $198.00 Investor sells to close the October $230.00 put for $33.00 Investor buys to open the October $190.00 put for $7.00 The investor has extracted a $26.00 net debit from the options which they use to reduce the average cost base (breakeven) of their original position. In addition, the investor now has 100% of the upside of the stock and has a new protection in place to remove all risk below $190.00 a share. As stated above, the investor can simply do nothing and defer making a decision until October, but dependent on their expectations on the stock, it may be appropriate to take action when and if it is timely to do so.
Canadian bank stocks have been somewhat unfavorable this year. Concerns about the Canadian economy, the impact of low oil prices and the pressure on lending margins from lower interest rates have had many investors questioning just how much more upside can be expected.
The chart below is a snap shot of the weekly price action for ZEB.TO which is the BMO S&P/TSX Equal Weight Banks Index ETF. Note the significant volatility in price action from December 2014 to present. The technical pattern that has developed is known as a sideways triangle. This pattern forms as a result of highs getting lower as indicated by the upper trend line and lows getting higher as indicated by the lower trend line
This pattern is associated with indecisiveness. After all, an uptrend will consistently make higher highs while a down trend will consistently make lower lows. Based on a current analysis of the chart, we have seen neither higher highs nor lower lows. This suggests that investors are just not sure what direction the banks are heading.
Now, despite positive second quarter earnings in May, we have seen the banks largely sell off for the last several weeks. That said, if we take a look at the ZEB.TO chart on a daily time frame, we can see that prices may be starting to break higher.
- Break above the 200 bar moving average. While this is not necessarily a guarantee of a continued bullish trend in banks, it does bring the price back above it’s long term trend line
- Bullish flag pattern that indicates a possible continuation higher
So how can we take advantage of this?
Let’s assume that an investor wants to lock in today’s price just in case the shares take off. On the other hand, if the shares pull back further, they are happy to own ZEB.TO shares at a lower price. One strategy that they can use is a variation of a synthetic long stock position using options. By definition, a synthetic long stock position involves the purchase of an at-the-money call option while selling an at-the money put option. The credit from the written put offsets a portion of the purchased call and the risk on the positions is comparable to owning the stock itself.
My variation would have the investor purchase a slightly in-the-money call, but sell an out-of-the-money put. The long call offers the investor an opportunity to benefit from an immediate rise in the stock and the right to purchase the shares at the strike selected, regardless of how high the shares trade. However, to offset the cost of this option and lower the break-even point, we can sell the out-of-the-money put and collect the premium. The reason an investor would consider selling the put at a lower strike is because they are willing to own the shares at that price if ZEB.TO sold off.
With shares of the ZEB.TO trading currently at $22.75
BUY December 22 strike CALL - $1.30 debit
SELL December 20 strike PUT - $0.30 credit
Net Debit = $1.00
The investor has the right to own the shares at $22.00 and has reduced the cost of the long call position to $1.00. The Break even on the upside is now $23.00. With the shares at $22.75, the position is only $0.25 away from break even.
If the shares drop in value, the investors risk is limited to the $1.00 net cost until the shares are trading at or below $20.00. At that point, the investor may be assigned and will take possession of the shares at $20.00. The break even on the position would be $21.00 based on the original cost. Once the investor takes possession of the shares at $20.00, the risk is unidentified. Bare in mind a covered call may be written or a protective put purchased at that point to help mitigate the risk.
2 Year Time Frame
This strategy offers the investor who wants to own the stock the best of both worlds. If the shares take off, the 22 strike call guarantees the investor the right to own ZEB.TO at $22.00 regardless of how high the shares trade. The investor would also have the choice to sell the call for a profit instead of buying the shares if they were satisfied with the move.
If ZEB.TO drops in value, the investor has the opportunity to own the shares almost 10% lower, but must be aware of the unidentified risk once they have taken possession of the shares.
The Canadian dollar has fallen on hard times. The Canadian dollar tends to follow West Texas Crude so it’s not surprising to see our Loonie trading close to 80 cents US. With lower Canadian interest rates and a US rate hike all but assured the Loonie may week stay in its current range for some time.
If you buy into that scenario you want to look for companies that benefit from a lower dollar. Specifically exporters like West Fraser Timber (symbol WFT, Fridays close: $68.13) which derives close to 50% of its revenue from sales to the US.
To that point, we could see a pickup in sales as the US job market strengthens which plays into WFT’s prime demographic, specifically 30 to 40 something first time home buyers. Low oil prices means more disposable income for this demographic and by extension continued easing in 30 year fixed mortgages rates.
The company made some decent gains in the first quarter but has since settled back to the point where the share price is effectively flat on the year. As such we may not see significant improvement in the share price through the remainder of the year, but on the other hand, I don’t see significant downside either.
In other words, WFT may remain in a trading range which plays into a covered call strategy or cash secured put strategy. If the Canadian dollar continues to decline and the prime home buyer demographic plays out as anticipated, WFT could pick up steam sometime in the first quarter of 2016.
In the interim, you could buy the shares and write the January $70 calls at $4.55 per share. There is not much liquidity in these options so consider this as a six month position. If the shares are called away in January, the six month return is 9.4% excluding dividends (note the company pays a 28 cents annual dividend). If the stock remains the same, the return is 6.7% with downside break even at $63.58.
Another approach would be to sell the WFT January $68 puts at $5.25 per share. With this trade’ you are committing to buy the shares at $68 per share less the $5.25 per share premium received. The net cost should the shares be put to you is $62.75. There is good support at $60 per share but should the stock break below that level, consider closing out the short puts.
In full disclosure, it is my intention to be contentious in my views as I am disappointed by the lack of diverging opinions. The Canadian economy is in trouble and it is likely to get far worse than better and it is unlikely that the passage of time will fix the problem. Here are some simple truths you must consider when reading consensus perspectives.
Investor and business confidence toward the economy is one of the most important drivers. Therefore, one has to recognize that Stephen Poloz and the Bank of Canada must instill that confidence when speaking, even during dire times. Equally, the street is full of sell side analysts and economists, which invariably express a glass-half-full perspective. The bottom line is that even if they knew the truth was dire, they would not dare publicly be caught saying so. Therefore, it up to us to read the macroeconomic tea leaves to assess market conditions. So let’s review some of the key considerations.
It is more than obvious that one can turn to the collapse in oil prices as the catalyst. However, the real risks may not be the price of oil itself, but a negative economic feedback loop that could force a broader economic slowdown throughout the entire economy. If the impact of oil was to be looked at in isolation, Canada would likely be able to weather the storm, but when combined with a number of concerning economic considerations, one can see the vulnerability to a contagion effect.
The first consideration is real estate. There have been many skeptics that have been sounding the alarm bells of Canada’s expensive and overheated real estate market, but none were as alarming as when the IMF raises the red flag. The IMF concluded that the real estate in the biggest Canadian cities was the second least affordable market in the world next to Hong Kong. This is particularly concerning as much of the job growth in Canada was attributed to the energy and housing markets.
House prices could in theory be sustained and a soft landing could plausibly occur, but it would rely heavily on stability in Canadian household income and confidence. What makes the situation concerning is the lack of wage inflation and the growing levels of household debt. While the Bank of Canada has suggested that the numbers have stabilized, one still must recognize that the average Canadian household carries 163% of debt to disposable income, one of the highest debt levels in the world. When the Bank of Canada looks to stimulate an economic turn, will the consumer have the confidence and the financial capacity to borrow and spend like they have in the past?
The last consideration is that there is little to no new capital investment initiatives to drive a considerable economic difference for the remainder of this decade. In my opinion, in order to be bullish Canada, it is not just predicting commodity and real estate stability, but rather recognizing where the future growth will emerge and this is where my concerns are focused.
To summarize, you have energy and resource consolidation, an overheated real estate market, a substantial debt burden on the average Canadian and almost no new sources of future growth. With that in consideration, it is hard to see how the Canadian Banks can go unscathed. So many Canadians label banks as conservative and stable securities. While they often do behave that way, one must accept the reality that banks are very highly leveraged profit machines. During periods of economic stability, they cannot help making large sums of money that they distribute generously to their shareholders through dividends. The problem is that when you have a highly leveraged balance sheet, during economic uncertainty, the leverage can dramatically work against them.
While I am not predicting an imminent decline, it is in my opinion that investors should educate themselves on option hedging strategies to manage unexpected risks. While hedging does have a cost, it comes at a benefit of reducing volatility and risk. As an example, we have an investor was to have owned 1,000 shares of CIBC for many years at an average cost of $60. With the stock trading at $95.00, the investor is concerned about the risk into the 3rd quarter. The investor buys 10 October $84.00 puts for $1.00 or $1000.00. Over that holding period the investor will receive two $1.06 quarterly dividends or $2,120 total. Essentially the investor is using a part of their dividends to remove the risk of a violent unexpected drop and put a floor under the stock limiting the risk to about a 10% draw down . A simple step like this can give the investor the confidence to hold the stock, even in uncertain market conditions. It is up to each investor to decide how to position themselves, but ask yourself a simple question - is the dividend and further upside worth the risk of being without a hedge?
Download Richard Croft’s presentation: The Road Ahead: What’s Next for Canadian Advisors? and discover what to expect in the coming months and how you can naviguate better the economic environment.
Option trading is rarely static. Cost / benefit metrics can change quickly causing one to rethink whether the initial assessment underpinning a trade is still in play. Often follow up strategies are required to either minimize losses on trades that miss the mark or up the ante on profitable positions.
Ideally, follow up strategies should be set out before any new position is established. It’s important to establish a range of outcomes and what steps might be taken should the underlying security realign beyond initial expectations.
For example, let’s assume that three months ago, XYZ was trading at $23.50 per share. At the time, we will assume that XYZ August $25 calls were trading at $2.00 per share. A six month covered write would yield 16.3% if XYZ is called away and 9.3% if the underlying remains the same. Downside breakeven is $21.50. Decent metrics assuming you are mildly bullish about the short term prospects for XYZ.
Fast forward three months and XYZ is trading at $29 per share. Analysts have upped their price targets and the XYZ August $25 call is trading at $4.50. Most traders do not enjoy the positive experience of earning the maximum potential return. Instead, traders focus on the risks that underpin covered call writing. Which is to say, you lose the best performing stocks in your portfolio.
The XYZ example raises three very basic questions; 1) was your initial assessment that lead to the sale of the covered call reasonable? 2) has that assessment changed because of market or company specific conditions? and 3) are there follow up strategies that could be implemented to enhance the returns from the original position?
Follow up strategies come in two forms. There are repair strategies designed to minimize potential losses and enhancement strategies designed to increase the potential profit from a position. In this case circumstances dictate the latter approach.
The most common tactic is to roll up the covered call to a higher strike with either the same or longer dated expiration. In this case, re-purchasing the initial August $25 call at $4.50 and selling say the XYZ August $30 call at $1.00. The total cost to roll up the position is $1.50 (i.e. $2.00 + $1.00 from the sale of the two calls less the $4.50 cost to re-purchase the initial call).
The new covered write ups the potential return to 33.3% if the stock is called away or 28.9% if the stock remains where it is. But at the same time, it raises the downside breakeven to $22.50 per share.
An alternative to the roll up enhancement is to close out the initial position and replace it with a bull put spread. It all depends on a new assessment.
A bull put spread involves the sale of a put with a higher strike and the purchase of a put with a lower strike. The position produces a net credit and requires margin. However assuming the original covered write was paid in full, additional capital will not be required.
With XYZ at $29 per share, you could sell the XYZ August $32.50 put (valued at $3.75) and buy the August $27.50 put for $0.75. The per-share net credit is $2.50 with the downside risk limited to $2.50 should the stock fall back. However, you have already made $2.50 per share on your initial position so your overall risk at this point is negligible. No matter where the stock ends up!
The rub with either follow up enhancement strategy is the whipsaw effect should the underlying security fall. And that is the classic debate faced by option traders; does the underlying security continue to rally or regress to the mean?
Dealing with that debate is made more difficult if you have not given thought to exit alternatives at the outset. Decisions made in a vacuum often end badly.
Announced late April, but effective as of January 1st 2015, Canadians are now entitled to contribute $10,000.00 to their Tax Free Savings Account on a yearly basis, up from $5,500.00 last year. As of now, it makes the total contribution limit $41,000.00.
According to news sources, the Liberals are on record opposing this increase by the Conservative party and that they prefer the limit remain at $5,000.00. Depending on how Canadians vote comes election time, this bump in contribution limits may be short lived, but for now it’s worth taking advantage of.
TFSA’s offer a shelter from taxation on profits generated on after tax dollars. While taxes are paid on the capital before it is deposited, profits are free to grow, compound and be withdrawn without taxation.
While an RRSP offers the investor shelter from the immediate taxation of capital gains, tax will be paid upon withdrawal whereas profits from gains in a TFSA account can be withdrawn at any time and are not subjected to taxation.
Many investors are unaware that they can actually apply a number of option strategies in their registered accounts.
Since 2005, the following strategies have been permissible:
- Buying calls as a stock replacement strategy
- Buying calls to secure the purchase price of a stock you wish to own in the future
- Buying puts to trade a bearish view
- Buying puts for protection
- Covered calls