This week, rather than looking at short term trading opportunities, we will examine a longer term strategy that is not dependent on a directional bet for the underlying stock. What it comes down to is positioning. Is this a stock you would be willing to hold longer term, what role will it play in your portfolio (i.e. risk reduction, return enhancement, etc.), what cost is reasonable? Assuming you are comfortable holding the underlying stock and have a rudimentary understanding of the role it will play in your portfolio, options can address acquisition cost.
The acquisition strategy is a covered combination on a volatile stock that is designed to take advantage of dollar cost averaging. A volatile stock has a greater impact on the range of outcomes for the strategy. In much the same way as volatility enhances the outcome when acquiring a position through dollar cost averaging.
To that point we’ll focus on two examples; Goldcorp Inc. (Symbol: G, Fridays close $20.75) and Valeant Pharmaceuticals (VRX, $40.14).
Company specific issues aside, the case for Goldcorp rests almost entirely on your outlook for gold. If that outlook is positive and you want to increase exposure to gold in your portfolio, the covered combination is an excellent way to manage the acquisition of shares.
We’ll assume for example that you are comfortable owning 1,000 shares of Goldcorp in your portfolio. We begin by purchasing 500 shares of Goldcorp at $20.75. We immediately sell five Goldcorp January (2018) 21 calls and five January (2018) 21 puts for a net credit of $8.60. Note these options expire in January 2018, which is seventeen months from now.
At the January 2018 expiration one of three outcomes will occur; the stock will rise above $21, fall or stay the same. If Goldcorp is trading above $21 in January 2018, the Jan 21 puts will expire worthless and the Jan 21 calls will be exercised. Under this scenario you would deliver your initial 500 shares to the call buyer. Your out of pocket cost to buy the initial 500 shares was $12.15 ($20.75 less $8.60 in option premium = $12.15). The seventeen-month return on the initial position would be 72.8%. This assumes of course that you are using margin rather than cash to secure the short puts and does not take into account the seventeen monthly dividends that you would receive while holding the shares.
If the stock stays the same or declines, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 500 shares of Goldcorp at $21.00 per share. At this point you would have acquired your 1,000 share objective at an average cost of $16.575. You should be comfortable holding 1,000 shares of Goldcorp at the average acquisition cost.
Now to Valeant Pharmaceuticals whose options options are trading in the top quartile of implied volatility. The high premiums are reflecting market concerns over management missteps. But, if you believe that past missteps are a sign post and not a hitching post, and believe this is a stock that can enhance longer term performance within a diversified portfolio, the covered combination can play a valuable role.
We’ll assume you are looking to acquire 400 shares of Valeant. We begin by purchasing 200 shares at $40.14. We immediately sell Valeant April 40 calls and April 40 puts for a minimum net credit of $18.50. These are not liquid options so be sure to use limit orders.
At the April 2017 expiration Valeant will be either above or below $40 per share. If Valeant stays the same or rises, the April 40 puts will expire worthless and the April 40 calls will be exercised. Under this scenario you would deliver the initial 200 shares to the call buyer. Your out of pocket cost to buy the initial 200 shares was $21.64 ($40.14 less $18.50 in option premium = $21.64). The eight-month return on the initial position would be 84.8%. Again assuming margin rather than cash is used to secure the short puts.
If the stock declines below $40 per share at the April expiration, the calls will expire worthless and the puts will be assigned. In this case you would be obligated to buy an additional 200 shares of Valeant at $40.00 per share. The average cost for the 400 shares would be $30.82. You need to be comfortable with the average cost base for the 400 shares.
Covered call writing is a low risk option strategy. If the underlying rises above the strike price the calls are assigned, you deliver the shares and exit with the best case scenario.
Covered calls make money in a rising or flat market and because the premium received reduces the cost of the underlying shares, is less risky than an outright long position in the stock.
Maximum return is at the strike price of the call, maximum risk occurs if the underlying declines to zero. Although to be fair, maximum risk is a function of the underlying security not the strategy.
Now look at naked put writing. Characterizing any strategy as “naked” implies risk. One is not “covered” by a long position in the underlying but rather is taking on a commitment to buy shares at a specific price for a pre-determined time period.
But here’s the rub; If the naked put writer secures the obligation with cash (i.e. cash secured put) is the strategy riskier than covered calls? Maximum return occurs at the strike price, maximum risk if the underlying decline to zero. In short – pardon the pun - covered calls and cash secured puts are equivalent positions.
So what leads an investor to employ one position and not the other? One reason is the regulatory environment which does not allow the sale of puts inside registered plans (i.e. RRSPs, RRIFs, RESPs, TFSAs). Simply stated the inherent obligation to buy whether secured with cash or not, requires margin. Registered plans are not marginable.
You have to be approved for a higher level of option trading when executing naked option positions. And there are good reasons for that! Put writers tend to leverage their exposure to an underlying security. Cash secured positions are not set in stone because you can always tap the cash being used to secure the position. Very different from the covered call writer who would have to sell shares in order to raise cash.
On the positive side a cash secured put can be executed with a single trade… one commission, one bid ask spread. That can be useful if you need to exit a losing position.
It can also benefit when trading positions on foreign markets. If you buy a dividend paying US stock you are subjected to withholding tax on the dividends and foreign exchange risk on the entire position.
If you write a put to buy a US stock and secure it with case held in Canada, you eliminate most of the foreign currency risk. Also the put premium takes into account any dividends payable by the underlying security.
Once a short put position is established be mindful of certain twists like the erosion of time value. Typically, time value for in-the-money puts erodes more rapidly than for in-the-money call options. And while that can be an advantage the rapid erosion of time value on in-the-money puts increases the likelihood that the puts will be assigned early. That happens more often than not particularly if a dividend payment is imminent.
So despite the fact that covered calls and naked puts are equivalent positions it is important to understand the subtleties associated with each strategy.
Something weird is happening in the energy markets… Oil and gas stocks seemed to stop caring what oil is doing. The divergences are staggering. What do I mean? Back in May, when crude oil was at its $50+ peak level, there was jubilee amongst investors. It has become consensus that oil has not only bottomed but is discovering a new range in the $45-$60 range to bring stability back into the battered energy markets.
How did investors react? They bought up the senior energy companies like it was the buying opportunity of a life time. With no bias, I will utilize the shares of Canadian Natural Resources TSX:CNQ (Referenced as CNQ). I can assure you that investors who did buy CNQ at $22.00 a share are feeling good about themselves, but I have to ask, does that make it safe buying new positions at $40.00 a share today?
Naively, I am going to make a basic observation as to what price levels CNQ traded at as compared to crude prices.
WTI Crude Oil Price $
Canadian Natural Res (CNQ)
February 10, 2014
October 6, 2014
April 30, 2015
July 29, 2016
Maybe I am missing something, but I just cannot bring myself to justify paying $40.00 a share for CNQ, when it represents the same price that the stock traded when crude oil traded 50-100% higher than it is today.
What could some of the factors be driving the divergence?
1. Lack of alterative value sectors - Back in January 2016, many of the senior oil companies were trading at levels not seen in decades, discounting some extremely bearish outlier scenarios. This drove value investors, and later momentum and technical traders to follow.
2. Search for yield - With bond yields collapsing to historic lows, income investors have been starved for yield. Once it became clear that many senior oil companies were not going to cut their dividends (at least not initially), investors could not help themselves trying to catch a potential bottom.
3. Index weighting - The Canadian S&P/TSX60 is 20.38% weighted into energy (July 29,2016). After the January 2016 lows, domestic and international investors were buying the Canadian market broadly looking to participate in a potential bottom in the resource markets. This broad index buying weighs money into energy irrespective of current macro fundamentals.
What has this created? A market where oil stocks are trading at price/earnings multiples that are normally reserved for high growth tech companies. Observe the chart below.
So what could an investor do beyond outright selling everything? Hedge!
After such a strong run higher, any investor that has bought an energy company over the last 6 months is likely profitable or close to it. This is when buying a protective put with some of the profits may be a solid alternative to selling. The buying of the put option ensures that you locked in a guaranteed sale price, allows you to continue to collect the dividends and prevents you from incurring a tax disposition in the sale of the stock.
When you own a put option, it gives you the control in the decision to exercise the right to sell. Alternatively, if profitable on the put option, the investor can simply monetize the profit. At minimum, for investors that are new to options, it is worth knowing all the alternative investment choices beyond just the traditional buy/sell trading decision.
When most investors think about selling covered calls, they think in terms of writing calls against individual stocks. Less often we think about writing covered calls against exchange traded funds (ETFs). Too bad really, because there are some interesting opportunities in that market space.
Trading ETFs reduces the impact of company specific risk which is defined as an event that can affect a company without necessarily the sector or market. Drug trials being a classic case where the success or failure of a particular drug can impact the sponsoring company with little or no effect on the sector.
While traders are pretty good at evaluating risk in a sector or the broader market, individual corporate risks are, for the most part, unknown. Which means the option market cannot quantify these risks! And that itself is a risk because a material event can exponentially impact the value of the underlying stock.
What tends to happen is that options overstate risk within sectors and the broader market while understating risk among individual companies. Proof can be seen in the performance of the Mx Covered Call Writers (MCWX) Index.
The MCWX is a benchmark that tracks the performance resulting from the rolling sale of one month at-the-money calls against a long position in the iShares S&P TSX 60 ETF (symbol XIU). With data back to 1992 we see that the options market has regularly overstated the actual historical volatility of holding XIU.
It makes sense that index option buyers tend to overpay. There is only one decision to make; are you bullish or bearish on the market? No second guessing about which sectors will outperform or which stocks within a sector will stand out. And of course, no risk of being blindsided by a material event that could not possibly be predicted.
Another consideration is downside risk. Individual companies can go bankrupt, ETFs cannot. That zero is never the worst case scenario is a positive for the covered call strategy. Bottom line covered calls on ETFs provides better risk reward metrics.
The challenge with selling ETF covered calls in Canada is liquidity constraints on many of the names. Still there are opportunities with enough liquidity to trade. Particularly within sector ETFs. For example, you might look at writing covered calls on iShares S&P/TSX Capped Energy Index ETF (XEG), iShares S&P/TSX Global Gold Index ETF (XGD) and iShares S&P/TSX Capped Financials Index ETF (XFN).
As anyone who has ever traded knows, the best laid plans pften go awry. Before making any adjustments, the investor needs to dissect what went wrong. Does he or she still hold fast to their original forecast but has simply run out of time, or was the strategy selection itself incorrect% Remember that closing the position full or cutting down the size of the position are always valid choices.
Read full article here: Of Mice and Men and Rolling Options
There are many factors one should think about when making specific investment decisions. Momentum, sentiment, fundamentals, quantitative metrics, value models… the list goes on!
That said successful traders share a common thread. They have established principles for selecting the right stock, strategy or position and are able to manage risk once the position has been established.
It comes down to a recognition that financial markets reward different strategies at points along the business cycle. Sometimes covered calls make the most sense, other times buying calls is the preferred strategy. Volatility trades make sense when volatility troughs or expands dramatically. Leverage is useful at certain stages while other times hedging is a better approach.
Think of these strategies in terms of “risk-on-risk-off”! The point being, reasonable investment strategies will profit at some point of the market cycle. The trick is managing risk during periods when the market is not rewarding your selected strategy.
How you manage risk depends to a large extent on whether you are a trader or long term investor. Traders need to think in terms of cutting losses and letting profits run. Long term investors tend to set reasonable targets for selling and often will hold or average down a losing position assuming the fundamentals have not changed. In theory, if XYZ was a good buy at $50 it must be a screaming buy at $40.
Since this is an option blog we assume most readers are active traders. As such, averaging down takes a back seat to cutting losses. Not to mention the time constraints and volatility expansion that accompanies a losing option position. Setting upside price targets is equally irrelevant as it goes against the grain of letting profits run.
A better approach is to think about new positions in terms of risk. How much downside will you undertake in a particular position? Stop losses are one approach but not particularly effective with options. A better mathematical approach is to use percentage moves as your line in the sand.
To that point think about a long call position. Since a long call has limited risk, the most you can lose is 100% of your investment. On the other hand, you can gain more than 100% on a winning position. So your starting point should be 100% downside more than 100% upside.
The challenge with long option positions is the erosion of time value. That’s a constant which means that your losing positions will likely outnumber your profitable trades. Given that it makes more sense to apply a tighter downside band than upside boundary. Think about exiting a long position if it declines by 50%. If you paid $5.00 for a call you would close the position if it fell to $2.50. As for the upside the 100% gain should be the demarcation line. Look to start exiting when the position has gained 100%. At that point you might swell half your position. Easier to let profits run when you have no capital at risk.
Another approach if you believe the momentum will continue, is to roll up a successful trade. Sell the initial position at a 100% or better profit and roll up to a slightly out-of-the-money call to take advantage of further upside. Rolling up means entering a new position following the same criteria of the initial position; sell if losses hit 50%, continue to hold until profits hit 100%.
If you prefer option writing strategies take into account that time is now on your side. However, when writing puts or uncovered calls your downside could be greater than 100%. Limiting the downside to 50% becomes critical.
Covered call writing is another common strategy where cash management plays an important role. With the covered call you own the underlying shares. You should have a much tighter line in the sand for cutting losses should the stock decline. As a rule of thumb think about cutting losses if the stock declines 20%. Since this is a covered call, a 20% loss on the stock is probably less than a 15% loss on the overall position.
Managing risk for an active trader is based on a set of mathematical probabilities. The downside triggers require discipline and the emotional makeup to admit a mistake. More importantly you cannot abandon the math should one of your exited positions whipsaw into profitability. Past trades should be a sign post not a hitching post.
It is difficult to make money trading options. If you doubt that statement, you probably haven’t been trading long enough.
Of course recognizing that it is difficult to make money should not cause you to avoid a market altogether. The trick is to mitigate as much as possible your losses, by utilizing option strategies that generally have higher than normal expected returns.
Before getting into this concept it is important to understand there is a big difference between expected return and actual return. Expected return is a statistical concept that applies to the return one would expect on a specific strategy over a large number of trials.
We would expect, for example, that a typical coin flip would come up heads half the time. That doesn’t mean heads will come up half the time. In fact, there may be long stretches where either heads or tails could hit in succession. However, there are only two possible outcomes, so statistically, heads should ultimately hit half the time.
The same theory can be applied to stocks, although with a much wider range of possible outcomes. The volatility of the underlying stock and the profitability of the position are incorporated into an expected return calculation resulting a mathematical expectation of profit. Taken one trade at a time things could turn out very differently. However in the long run, the same strategy should generate a return that approximates its’ expected return.
Not that any of us will be around long enough to invest in the same position repeatedly over time. However, if your goal is to focus on a specific option strategy – covered call writing, bull call spreads, calendar spreads etc. – then look for a strategy with a positive expected return. And be ready to grin and bear it, if you run into stretches where the actual return is significantly different than the expected return.
So how does this work? To use a simple example let’s calculate an expected return on a bull call spread. To begin, we assume the following prices exist; XYZ trading at 52, the XYZ October 50 call is at 4.75 (implied volatility 35%, 97 days to expiry) and the XYZ October 60 call is at 1.25.
The XYZ bull call spread involves purchasing the October 50 call and selling the October 60 call for a net debit of $3.50 (4.75 less 1.25 = 3.50). The maximum potential profit for the bull call spread is $6.50 (assuming XYZ is above $60 at expiration) with a maximum loss of $3.50 (assuming XYZ is below $50 at expiration).
In an effort to simplify the discussion, we will assume that XYZ can only be at a few price points by the October expiration. The trick is to calculate the probability of XYZ being above or below specific price points. You can download an excel spreadsheet entitled “Probability of a Successful Option Trade” to assist with this calculation. The free spreadsheet can be downloaded at http://investexcel.net/category/option-pricing-2/.
Since this is a bullish trade employing calls, we are interested in the probability of the underlying stock being above certain price points at expiration. Using the aforementioned spreadsheet the following table looks at the probability of the stock being above a specific price:
Price % Above Profit (Loss) Expected Profit
50 41.40% (3.50) (1.45)
52 50.00% (1.50) (0.75)
54 41.72% 0.50 0.21
56 34.06% 2.50 0.85
58 27.25% 4.50 1.23
60 21.39% 6.50 1.39
Total Expected Profit 1.48
If the stock is below $50 at expiration, you would lose your $3.50 net debit. Multiply that loss by the 41.40% probability that the stock could be below that price (this probability calculation assumes a lognormal distribution of stock prices) and we get an expected profit (loss) of -$1.45. Above $60 per share, your actual profit is $6.50 but the expected profit is $1.39.
Assuming the stock will close at one of these price points, leaves this trade with an expected profit of +$1.48, which is simply the sum of all the potential expected profits.
If we divide the expected profit of $1.48 by the initial investment of $3.50, the expected return is calculated as 49.26%. To annualize the expected return on this 97 day position, we would multiply the result by 365/97 which gives us an expected return of 185%.
The annualized expected return helps us compare various strategies that expire at different times. Bearing in mind it is not likely that a similar position would actually exist in October when the initial position expires.
Armed with the expected return calculation let’s apply some real world trading techniques to the XYZ example. We begin by fast forwarding to August 1st, at which point we will assume that XYZ is trading at $56 per share.
The XYZ October 50 call would theoretically be worth $7.15 and the XYZ October 60 call $2.00. The spread would have widened to $5.15, generating a profit of $1.60 (not counting transaction costs). At this point the $1.60 profit is greater than the $1.48 total expected return.
Given this scenario you should think about exiting the position, or at least selling a portion of the spread. By taking profits, you are recognizing that expected return is a statistical concept derived from a large number or transactions. By seeking opportunities to take profits in specific positions, you are using real world trading to augment statistical certainties.
Expected return is a useful concept for beginning option traders. It is also useful for brokers who want to add value to clients who have a preference for a certain type of strategy. If nothing else, it may provide you some comfort, knowing that every time you lose money in an option trade, you are one step closer to benefiting from the mathematics of expected return. Or not!
When most investors think about option writing strategies, they think about writing calls against individual stocks. Buy shares of BCE, Suncor or Royal Bank and sell covered calls.
While not as popular, covered call writing against exchange traded funds offers some interesting twists for lower risk investors. One notable advantage is diversification
which reduces non-systemic risk. That being the risk unique to individual companies. Transportation margins which depend on fuel prices, minimum wage issues for fast food restaurants, regulatory change a within the financial sector, etc.
Company or industry-specific hazards that are inherent in single stocks or sectors must be factored into the investment decision. But typically, such factors are unpredictable. Non-systemic risk, also known as “company specific risk,” “diversifiable risk” or “residual risk,” can be reduced through diversification. An ETF like the iShares S&P TSX 60 Index Fund (symbol XIU, Fridays’ close $20.56) spread across many sectors being the ultimate diversifier within an asset class.
If we broaden the concept, owning other assets such as bonds, preferred shares, real estate and alternative strategies can reduce non-systemic risk in a portfolio.
Coming full circle investors must recognize that the unpredictable nature of non-systemic risk means that by extension, it cannot be quantified effectively by the options market. The premium one pays to buy or receives when selling an option, is really a function of how much risk traders believe there is in the underlying security. On an individual stock, there is really no way to assess company specific risk which means that stock option premiums often understate the real risk within an individual stock. With an ETF you do not have to evaluate company specific risk, only sector risk – in the case of a sector ETF - or market risk – in the case of broader market indices.
ETFs also have limited downside. Whereas individual companies can go bankrupt, ETFs cannot, effectively eliminating zero as the worst case scenario. Also index option premiums typically overstate the risk in specific ETFs. Historically, the volatility implied by options on XIU almost consistently overstate the actual volatility displayed by the ETF. Which is to say XIU options are almost always overpriced.
Supporting that position is the historical performance metrics with the Mx Covered Call Writers (MCWX) Index. MCMX is simply an index that examines the returns generated by regularly writing one month calls on a long position in XIU. Data back to 1992 shows that the XIU call options have regularly overstated the actual volatility associated with a buy and hold strategy on XIU. Meaning that MCMX has consistently outperformed buy and hold on a nominal and risk adjusted basis.
Never was that more evident than during the financial crisis. ETF option premiums expanded dramatically, which provided an effective hedging tool for investor employing covered call writing as a strategy.
Today as investors have become more complacent option premiums have contracted. Note the Canadian Volatility Index (symbol: VIXC) which measures the implied volatility on XIU options, closed Friday at 13.07%. During the first quarter of 2008 that number was in the mid-20% volatility range.
If you are inclined to write covered calls against broad market indices, consider buying shares of the XIU and writing close to the money three to six month calls against the units.
More aggressive traders might consider writing covered calls against sector indices using ETFs like iShares S&P/TSX Global Gold Index ETF (symbol XGD) or iShares S&P/TSX Capped Energy Index ETF (symbol: XEG). The trick is to ensure that you choose sector indices that you have a feel for and that have sufficient liquidity to allow movement in and out of positions.
To that latter point look at the open interest and volume numbers for the individual options. Being able to pick the direction of a specific ETF will only produce a profit if you are able to enter and exit positions with minimal bid ask spreads.
Writing options against ETFs is not as exciting as writing calls against individual stocks. However, considering that many individual stocks have been driven almost exclusively by non-systemic risks and knowing that individual stock options are relatively cheap (i.e. understating the impact of non-systemic risk), writing covered calls against ETFs may prove to be the superior strategy through the end of this year.