Of Mice and Men and Rolling Options

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

Managing Risk

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.

Investors Options Trading Letter - June 2016 Issue

Expected Return A statistical concept with a real world application

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!

July Option Workshops

Register to our free sessions and enhance your options trading skills.

For further details, visit our website at: http://www.m-x.ca/f_publications_en/atelier_option_workshop.pdf

The ETF Option Advantage

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.

Hedging Risks on Canadian Banks

On June 9th, the Bank of Canada released their Financial System Review.  The press conference opening statement highlighted some interesting considerations. Stephen Poloz said:

The first two vulnerabilities, household indebtedness and imbalances in the housing market, have both moved higher since our last report. However, in view of the improving economic outlook, there is now a lower probability that the risks stemming from these vulnerabilities will be triggered. This combination of higher vulnerabilities but lower probability leaves the financial stability risks related to those vulnerabilities roughly unchanged from our last report. Our view is still that a strengthening economy and rising incomes will reduce these vulnerabilities over time for the country as a whole.

Nevertheless, it was the view of Governing Council that this conclusion merited a caveat, which is that the pace of house price increases in Toronto, and especially Vancouver, is unlikely to be sustained, given underlying fundamentals. This suggests that prospective home buyers and their lenders should not extrapolate recent real estate price performance into the future when contemplating a transaction. Indeed, the potential for a downturn in prices in these markets, although difficult to quantify, is growing. A significant decline in house prices could have material consequences for some individuals and for some entities in the mortgage business. However, the financial system as a whole is resilient enough to handle the potential impact. http://www.bankofcanada.ca/2016/06/opening-statement-090616/

Subsequently, in a Globe and Mail article titled: A Domestic Housing Crisis Would Look Nothing Like 2008, http://www.theglobeandmail.com/globe-investor/inside-the-market/a-domestic-housing-crisis-will-look-nothing-like-2008/article30540846/, the article references that Moody’s Investor Services suggests that if there was a correction in real estate, the big banks could be at risk for $12 billion dollars in mortgage risks.

This could come at a time when S&P is warning that there could be More fallout from low oil prices expected for Canadian banks. http://business.financialpost.com/news/fp-street/more-fallout-from-low-oil-prices-expected-for-canadian-banks-sp-warns

In summary…. There are many risks and headwinds that the banks will need to face in the upcoming few years, yet, most of the Tier 1 Canadian banks are trading a stone’s throw away from their 52 week highs.

I ask a simple question - are all the worse case scenarios priced in?  Personally I am sceptical.

Without suggesting investors unload their shares, investors can consider overlaying an options strategy to try to hedge the risks.

The most common options strategy is to simply buy a protective put, in combination with the shares owned.  An additional strategy an investor could consider is sell a covered call at higher strikes to offset the cost of the protection (collar strategy), or simply selling the calls to enhance the income and reduce the cost base of the shares.

As an example utilizing Royal Bank shares, a buy and hold investor watched their shares rise over $10.00 from $65.00 a share in February to its current levels around $77.00.  Our investor is not concerned with the risk of a few dollars higher or lower, rather is looking to remove the outlier risk that financial conditions deteriorate.

In this case the investor buys the October $70.00 put option for $1.75 per share (price as of June 30th).  In this case, for just over a 2% cost, the investor can sleep well over the summer months knowing that if the shares were to deteriorate lower, their worst case scenario has been clearly defined.

Understanding Credit Spreads and How they Differ from Debits Spreads

In a previous posting, we learned how to implement a debit spread for both calls and puts. This week, we will examine another form of vertical spreads: credit spreads and how they can be used.

Understanding Credit Spreads and How they Differ from Debit Spreads

Brexit is a reality!

Brexit is a reality! Despite the betting odds, despite the financial markets’ expectation that we would see a “remain” outcome, the British electorate knowing for bucking the odds voted to exit the European Union.

And now we face the inevitable fallout. Unfiltered headline noise will set the stage this week. Witness the latest hot off the press headline noise; “Financial Markets in Free Fall;” “Volatility is Spiking;” “Gold is Surging;” “Currencies are in Disarray!” Remember this is noise and not what you should focus on when making investment decisions.

Fact is Canadian equities as measured by the iShares S&P/TSX 60 Index Fund (symbol XIU) fell 1.93% on Friday which puts the index back to where it was a week ago. The so-called spike in volatility is well below levels in February (the MX VIX Index closed Friday at 20.06, it closed as high as 31.99 in February this year). Gold is higher but not as much as you might think and is still well below levels from 2012 through 2014. Gold bugs are not seeing this as the global crisis that financial writers and doomsayers like to espouse.

The currency market is another story. The decline in the British Pound was monumental, clearly uncharted territory! And there may be more to come. Britain will most likely slip into a recession which may prompt Mark Carney head of the Bank of England to cut rates. Best guess is a snap 25 basis point cut which may further weaken the pound.

I believe the longer term implications will be political than economic. British Prime Minister David Cameron orchestrated this vote based on a promise he made to parliament in 2013. It was designed to appease members of his own party who felt that Britain gave up too much in negotiations with the EU. The lesson from this is that referendums don’t work well when dealing with complicated positions. Too often the economic message gets lost under the weight of political biases that gravitate to the lowest common denominator. In this case the leave camp played on the electorates’ xenophobia about lax immigration policies, unprotected borders and jobs. If you think that’s not the case watch closely as the US Presidential race heats up. It will play to the same storyline.

The trick in the weeks ahead is to separate the political meat from the skeleton. For example, the Scottish Parliament fresh off their own referendum that voted to remain within Britain mainly because doing so allowed Scotland unfettered access to the Eurozone, will probably introduce legislation to prevent the British parliament from enacting article 50 (the article that provides the process for exiting the Eurozone) with Scottish consent. It won’t matter but that will likely lead to another Scottish referendum to leave Britain which may well pass.

Northern Ireland will attempt to succeed from Britain to join Ireland which is an EU member. That will not likely pass muster with the Protestant majority in Northern Ireland, but will nevertheless be fodder for more headline noise.

Conspiracy theorists will say that the British exit will lead to more separations within the Eurozone. That’s not likely with the possible exception of Hungary. But that will have more to do with the political system. Hungary is a dictatorship and under the rules, only democracies can be members of the Eurozone. As for Italy, Spain or Greece, if they were going to leave they would have done so already.

I suspect that reality will begin to set in by mid-week. Any exit plan will take two to three years to implement. Most likely Britain will negotiate a partial union much like currently exists for Norway which pays about US $1 billion in annual dues to have access to the Eurozone. Norway must follow Eurozone rules but as a country remains independent.

As cooler heads prevail we may well see a rebound in equity markets once hedge funds and institutional portfolio managers have reset their portfolios based on revised earnings expectations. Which by the way will start to replace the headlines starting in July.

At this stage I would avoid committing serious money to hedging strategies. I think most of the damage has already occurred. Wait for opportunities to begin nibbling at new positions which could come as early as mid-week.

Richard N Croft

Gold versus Gold Stocks

Gold has been on a tear recently. Not because of any real change in supply demand metrics. This is all about defensive positioning against a perceived devaluation of paper currency. In short gold bulls are playing the crisis insurance card… again!

I am not about to tell you to buy gold. I’ve talked about it in the past but to be frank there are enough writers willing to talk gold up. Many with solid reasons supporting their position. So let’s assume that you should have some gold in your portfolio. The question I want to tackle is whether you should gain exposure through gold or gold stocks.

The most basic argument would tell you to bypass the producers and hold bullion. You can gain exposure to bullion through ETFs or for those who prefer tactile pleasures, you can buy the actual bullion from your local bank.

When buying gold mining stocks you are assuming risks beyond gold’s price action. Miners are susceptible to company specific events like labor unrest, management expertise or lack thereof, leverage and margins which can impact your investment in up and down markets.

To add some meat to that last point, many gold miners engage in hedging strategies. As such rising gold prices will not necessarily result in better margins if management has hedged the company’s forward production. On the flip side, hedging strategies benefit investors by maintaining margins during periods when gold’s price is declining.

Since I typically move in and out of gold as a momentum play I tend to gravitate to gold miners. As a momentum play miners should move more dramatically because of the aforementioned leverage. At the most granular level, miners are in the margin business where proper analysis can assign reasonable probabilities. That’s easier than trying to explain the hedging dynamics used to talk up gold’s price during periods of financial uncertainty.

The fact that miners tend to be more volatile adds another twist when viewed in terms of the options market. Higher volatility translates in higher option premiums which can be useful when looking at option writing strategies.

For example, suppose you are looking for some exposure to gold as a hedge. Using miners you could write covered calls. As a case in point consider Agnico Eagle (TSX: AEM, Friday’s close $64.69) where we could buy the shares and sell the August 66 calls at $4.30. If AEM is called away at $66 per share the net two month return on the position is 8.6%.

Now let’s look at buying gold bullion trading at US $1,286 or CDN $1,650, as our hedge. To get the same two month return as our covered call on AEM gold would have to go to rally more than US $110 or CDN $170 per ounce. So what is the probability that gold rises by that much over the next sixty days?

The answer can be found in the option pricing formula… specifically the delta. The answer is that there is a 22.7% chance that gold will close above US $1,397 over the next sixty days. It may well do that but personally I like the odds associated with the AEM covered call where there is better than a 50% chance the shares of AEM will close above the $66 strike by the August expiration.