The markets remain “choppy,” as the saying goes, gyrating quickly through gains and losses on low summertime volume, which tends to exaggerate swings. It’s best not to read too much into this type of activity. Second-half economic weakness had been widely predicted (including in these notes) in the first half of the year.

Still it’s difficult to bet on the sustainability of any trend. Mainly because there hasn’t been one! Stocks gyrate through gains and losses very rapidly in this environment, subject to swings in sentiment. Fundamental analysis founders on the shoals of uncertain earnings outlooks. Will it be inflation or deflation? Slow growth, no growth, or double-dip? It’s all on the table, and there’s no consensus… except perhaps, the very low probability of a double dip.

You could argue that markets have already discounted a slowdown. Note the persistent bearish bias since April. You could also make a case that mean reversion is the foundation for a choppy environment. Which, given the deeply pessimistic predilection driving investor decisions, suggests an upside surprise in the fall.

So, how can options traders profit from this type of trading environment? We know that rapid rallies and steep corrections lead to higher than average premiums. Leading one to look first at option writing strategies that generate cash flow in a range bound market. You could certainly look at writing covered calls or cash secured puts on sectors that will be hit hardest in a slow growth environment. Sectors like energy, materials and to a lesser extent, consumer staples come to mind.

One possibility for a short-term gain could be long calls on Canadian financials. The iShares S&P/TSX Capped Financials Index Fund (TSX: XFN, recent price $21.09) has been encountering support near its 52-week low. Even if it isn’t a true bottom, the bounce that took place on Friday may have a way to go to the upside. Look at buying the XFN Oct 21 calls at 70 cents. This is a short term trade, which traders should look to exit if the calls rally above $1.25.

You could also look at some of the individual banks that are included in XFN. For example, the big five Canadian banks make up 68% of the total XFN portfolio. As go the big five, so goes XFN.

Given the positive upside earning surprises delivered by CIBC (symbol CM, recent price $71.99) and Toronto Dominion (symbol TD, recent price $71.78), you might look at long calls on either bank. The CM Oct 72 calls at $1.85 look interesting as do the TD Oct 72 calls at $1.90. As with XFN, these are short term trades that you should look to exit if either call doubles.

Is this week’s surge in agri-business stocks like Potash Corp. (TSX: POT) and Agrium Inc. (TSX: AGU) overdone? Some analysts think that any price above $140 per share for POT is pure speculation. And yet by the end of the week, POT shares closed at $157.06.

No one believes POT is cheap. Takeover speculation often takes on a life of its own, with companies enticing bids that have no basis in logic.

In the current environment, a speculative frenzy is about the only way to describe the agri-business. Drought induced shortages in Russia have pushed up prices for wheat futures.

Reminds me of the last time agri-companies were setting new highs. Remember the government-mandated ethanol craze that caused shortages in soft commodities like corn and soybeans. But when further analysis calculated the miles per bushel of corn one would expect to get with a typical North American automobile, governments began to re-think the efficiency of using corn for ethanol rather than livestock feed. Warehouse inventories were quickly replenished, and agri-companies quickly fell to more rational levels.

The problem with commodity cycles is that by the time you learn there’s a mania, it’s probably too late. Increasing the likelihood that sans a speculative frenzy, the market will experience a sharp sell-off.

The recent agri-stock runups are already discounting some lofty expectations for future earnings. And if we assume that the primary driver of the current investing theme is the price of wheat today, then the sustainability of the rally in agri-stocks is questionable indeed.

Having said that, the advantage of limited risk entices option traders to play speculative frenzies. Speculating for example, that a POT bidding war will ensue that could take the price to $175 per share or higher. If you buy that, then buy POT September or October close to the money calls.

The POT September 160 calls are trading at $3.65 while the October 160 calls are at $5.75. If the speculative frenzy continues into this week, these calls could double or triple in value. The maximum risk is the cost of the calls.

If you are like me and are more skeptical about the outlook for the agri-business, you could look at AGU bear call spreads. Because AGU is not in play – yet! – it is benefiting from the POT saga without the ancillary takeover noise.

With AGU trading at $72.03, you could sell the AGU Oct 72 calls at $3.60 and buy the Oct 80 calls at $1.00. This bear call spread creates a $2.60 net credit with a maximum risk of $5.40 ($8.00 difference in strike prices less the net credit of $2.60 = $5.40 maximum risk). If AGU, were to fall back both calls would worthless and you would keep the net credit.

Option Matters will be closed until August 16th. We’re going to recharge our batteries for another year.

Enjoy summer!

At the opening of trading on Tuesday, August 3, 2010, MX will begin trading new options on the following four equities:

• Anatolia Minerals Development Limited – ANO
• Corridor Resources Inc. – CDH
• Gabriel Resources Ltd. – GBU
• Premier Gold Mines Limited – PG

On July 28th, the Montréal Exchange will launch a new “Education” section in the main navigation bar of the MX site. One of the key features of this section is to have links to our educational offerings (webinars, videos, blog, guides and strategies, workshops) in one location only. What’s more, we are adding educational content provided by The Options Industry Council under a content licensing agreement with MX.

Additional enhancements include:

• merger of the “About Us” and “Media Room” menus under one “About Us” menu for better content organisation;
• addition of an identifier to indicate a third-level menu;
• new “Affiliated Sites” quick links in the left column of the site.

We encourage you to navigate through the new Education section to learn more about the use of options.

The Canadian stock market has moved back and forth in a fairly narrow range (between $16.50 and $17.50 on the S&P/TSX 60 iShares (symbol XIU, Friday’s close $17.16). That said, there have been periods where the market has moved sharply higher or lower. Which is to say, volatility is high relative to the actual trading range of XIU.

Interestingly, the Canadian market has traded tightly around its 20-day moving average. No momentum. Typically strong upward moves – as we saw in early June – are followed by sharp sell-offs (witness the middle of June to early July).

Of course, markets eventually break out of a range. The question is when. And to this point I see nothing that suggests a serious break out in either direction until perhaps, the beginning of the fourth quarter.

With that in mind, traders might look at selling September straddles. Specifically selling the XIU Sept 17.50 calls at 30 cents and the XIU September 16.50 puts at 30 cents. The net premium received from the sale of the straddle is 60 cents.

This trade will be profitable if XIU is between $15.90 and $18.10 at the September expiration. The maximum profit occurs if the XIU closes anywhere between $16.50 and $17.50 at the September expiration.

At the opening of trading on Monday, July 26, 2010, long-term series will be added to the following option classes:

• Eldorado Gold Corporation - ELD
• Enbridge Inc. - ENB
• Nexen Inc. - NXY
• Osisko Mining Corporation - OSK
• Pacific Rubiales Energy Corp. - PRE
• Shoppers Drug Mart Corporation - SC

Is the Canadian market heading lower?  We are now two weeks off an important test of the January/February lows. If the market is simply retracing from an oversold state, then we should should see the Canadian market struggle at these overhead resistance levels. We will be observing if the 17.40-17.60 levels on the XIU contain all rally attempts.  If it does, then there are a number of bearish scenarios to consider. 

For more information watch our Canadian Market Minute video:
http://www.optionsource.net/mediaplayercanadian.php

My view last week was that the markets could reach their most recent highs (that would be approximately 12,000 on the TSX Composite Index or 10,400 on the Dow Jones Industrial Average). The TSX has yet to reach its mark. But the DJIA did and then pulled back… abruptly!

Earnings were expected to be positive. And many felt that would be enough to entice buyers back into the game. At least for the short term. But so far, earnings have been a mixed picture, and macro events continue to drag investor enthusiasm.

What’s clear is that global economies are not recovering as fast as expected. For that to change, consumer spending will have to step up big time. Especially as governments gradually withdraw stimulus programs.

The problem is that no one sees that happening. Which is why, after just a week of second quarter earnings, analysts are already lowering expectations.

Traders need to be cautious, and if anything, might want to reassert their bearish bias over the near term. Potential option strategies include 1) buying puts or 2) writing bear call spreads.

Buying puts is the first choice if premiums remain relatively low. Before deciding which strategy to use, check the levels on the MX Implied Volatility Index (symbol MVX). The MVX closed on Friday at 16.53. I would consider any level below 20 as a low number in the current market environment.

The S&P/TSX 60 Index Fund (TSX: XIU) closed Friday at $17.03. If you buy the bearish scenario, look at buying the XIU August 17 puts at 43 cents or better. The XIU options are liquid so you should have no difficulty moving in or out of any position.

Bear call spreads make more sense if option premiums make the cost of an outright purchase prohibitive. As mentioned, that would be any value above 20 on the MVX.

A bear call spread, like any spread, typically reduces the impact of volatility. A spread involves the simultaneous purchase and sale of options on the same underlying security. If you overpay for the long option, you are benefiting from the excess premium received on the sale of the short option. Effectively one option premium cancels the other.

Typically, you would sell an at-the-money or in-the-money call and simultaneously purchase of an out-of-the-money call. For example, with XIU, you could write the in-the-money August 16.50 calls at 75 cents and simultaneously purchase the out-of-the-money August 17.50 calls at 20 cents. This bear call spread generates a credit of 55 cents.

This spreads maximum profits occurs if, at the August expiration, XIU is below $16.50. At that point both of the XIU August calls expire worthless and you retain the net credit received.

The risk in this position is limited by the purchase of the August 17.50 call. If XIU were to rally above $17.50 between now and the August expiration, any additional losses on the short August $16.50 call would be offset by gains on the long August $17.50 call.

The maximum risk with the bear call spread is the difference in strike prices less the net credit received (Aug 17.50 call minus August 16.50 call = $1.00 risk less $0.55 net credit received = $0.45 net risk).

MX and the OIC are on the road again with our upcoming Options Education Days in Montréal (September 11th) and in Toronto (September 25th).

For information on the Montréal event, click here.

For information on the Toronto event, click here.

Don’t miss this opportunity to develop winning trading skills!