Understanding How to Exit before you Enter

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.

TFSA Contribution Levels Raised

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
While any of these strategies can offer the investor an edge over the traditional approach to managing their money, let’s consider the impact that the covered call strategy could have on the cash flow generated in a TFSA.
While stocks and exchange traded fund values may fluctuate up and down over the years, an investor implementing the covered call strategy could increase their non taxable income significantly.
Let’s assume that an investor is well diversified across multiple accounts and investments.  $41,000.00 in a TFSA may be considered risk capital and the investor is prepared to be a little more aggressive with the objective of achieving a higher rate of return.  Based on their analysis and expectations, they believe that Agnico Eagle Mines (TSE:AEM) is a good investment over the long term.  Having a substantial amount of diversified investments in other accounts, a $41,000.00 stake in this company represents a small portion of their overall net worth.
With TSE:AEM trading at $40.29, the investor could purchase approximately 1,000 shares.
I want to make it clear that I am not recommending that investors allocate all of their TFSA to one security.  Investors must consider their own personal circumstances and diversify their investments accordingly. That said, the covered call strategy could be applied to a basket of options eligible stocks spread across a number of different sectors. For the purpose of this example, TSE:AEM makes for an interesting consideration.  While the share price has been quite volatile, the option premiums have reflected this and are paying the covered call strategist generously for taking on the obligation to deliver the shares. As of Friday May 15th, the stock is trading at $40.29.  The June 2015 $42 call is bidding $1.15.
aem option chain
Selling this call against the shares of TSE:AEM obligates the investor to deliver the shares at $42 over the next 33 days. While the investor can profit on the shares by $1.71 if the stock rallies above the $42 strike, they have also generated $1.15 per share or almost 3 percent in cash flow.  On 1,000 shares, this represents $1,150.00 of tax free income in 1 month.
It is important to recognize that the risk associated with the covered call strategy lies with the underlying stock.  If the shares drop below the purchase price less any premium collected, the investor will be sitting with an unrealized loss.  Further to that, by selling close to the money calls, the investor has limited the potential upside.  Considering the risks, selling calls each month against the shares serves to mitigate the impact of a drop in the share price when an adverse move takes place. When the stock stays the same or increases in value, the investor has generated a respectable income on their investment.  This cash flow can be withdrawn tax free to be used at the investors discretion, applied to the purchase of additional shares or simply left to build up the free cash reserves in the account.
This example represents a covered call return that is on the higher side due to the volatility of TSE:AEM.  However, even on a diversified TFSA portfolio of options eligible stocks and ETF’s the compounding effect over the long term could result in a pretty impressive tax free return.

Hedging the Canadian Economic Recovery

On February 24, 2015, Stephan Poloz, Governor of the Bank of Canada made the following statement:

“The negative effects of lower oil prices hit the economy right away, and the various positives—more exports because of a stronger U.S. economy and a lower dollar, and more consumption spending as households spend less on fuel—will arrive only gradually, and are of uncertain size.” (Monetary Policy Report April 2015)

The TSX Composite Index has risen close to 1700 points since the December lows led by short term recoveries in the Canadian energy and banking stocks. At the same time, we have seen a first quarter bottom in the Canadian dollar at $0.78 with now a $0.05 recovery to the current levels. The recovery has been in part due to the more optimistic comments from Governor Poloz during the last Bank of Canada press conference.

While I won’t dispute that the Canadian economy has yet to demonstrate recessionary characteristics, there are some reasons why I am not sold on the recent turn back higher. So what do I worry about?

Irrespective of the recent bounce in oil prices, there has become a fundamental shift in the energy space. A recent Financial Post article suggested that the drop in oil prices has forced over US $114 billion in spending cuts. New projects have been canceled or put on hold. This does not change just because West Texas Crude trades to $60.00. These projects were a major source of jobs and investment banking revenues. These are not coming back overnight.

As stated at the start, Stephan Poloz suggests that this can be offset by a stronger U.S. economy, more exports and more consumption by households that are spending less on fuel. To me, these offsets are turning out to be duds. While our weaker dollar makes our exports more attractive, there isn’t much of a global recovery occurring around the world, so increases in gross exports are likely to be a monetary adjustment and not real growth. At the same time, the U.S. GDP numbers released today are showing almost no growth in the U.S. economy. Is that what we are counting on for a boost north of the boarder? The lower gas prices may not have the spending effect the BoC is hoping for. Heavily indebted Canadian consumers may use the lower gas prices as an opportunity to get their heads above water on what continues to be a very stressed household budget.

While I am not trying to be overly bearish, I simply do not see the current conditions as being ripe for a new economic growth cycle. At the same time, Canadian equities are vulnerable to a negative turn in European and American stock markets going into the 3rd quarter of the year.

I am not opposed to owning Canadian equities, but I am using the recent run higher in Canadian stocks as an opportunity lock in the advance with at-the-money protective puts, particularly on energy and bank stocks. Why? To me, unless you are really bullish on a Canadian recovery, the question is how can you justify not hedging the risks?

Optimizing Your Covered Call Strategy

Like a good dance lesson, writing covered calls is a two-step process. You need to be comfortable holding the underlying stock and should be happy if the stock is sold at the strike price of the short call. Having comfort with the underlying stock leads to the next step; which option to sell? Is there an optimum option to sell, should implied volatility enter into the decision, what about liquidity in case you want to buy the option back at a future date? These are fair questions to which there is, unfortunately, no right answer. Selecting which option to sell is as much art as science. The correct option is the best fit to your comfort index. For example, what strike price most closely aligns to your view of the underlying stock? What price are you willing to sell your shares? Or better yet, at what price are you unwilling to buy the shares? That is probably the strike price that most closely aligns with your comfort index. But then, what about downside protection? Certainly, you want the premium received to hedge some of your downside risk, which again plays into the strike price and time horizon. Simple rules of thumb tell us that aggressive traders want to leave room for upside potential and will probably write shorter term out-of-the-money calls. If you are positive about the underlying stock, write strikes that are further out-of-the-money. Of course being positive about a stock is a state of mind. If you are bullish and believe the stock has major upside potential, you probably should not be writing covered calls! Attempting to capture short term income using a strike that you do not think will be breeched does not work as often as you might expect. And if you are wrong about the stock’s potential, an out-of-the-money call provides little downside protection. Ideally, aggressive traders should only consider writing covered calls when they are mildly bullish or neutral on the prospects for the underlying stock. In which case, writing short term – i.e. one or two months to expiry – out-of-the-money calls would be the appropriate strategy. Conservative investors typically opt for downside protection by writing at or in-the-money calls with longer expirations. The value for conservative investors is the tax advantaged cash flow not the stock’s upside potential. The starting point for the aforementioned covered call strategies is that the investor is more focused on the underlying stock than with the option strategy. The covered call is simply a tool to manage the inherent volatility associated with the underlying stock. For investors who use covered calls as a core strategy, the underlying stock, while important, is not the end game. The cash flow from the sale of the calls is the beginning and the end of the strategy. The underlying stock is simply the vehicle that sets in motion the regular cash flow. Determining your comfort index and by extension the optimum covered call strategy depends on your investor profile – i.e. are you aggressive or conservative? – and whether covered call writing is a core or secondary strategy. Think about it this way. Your principal residence is where you live. You may rent out the basement occasionally, but any real return will come from the appreciation of the property. A rental property on the other hand, is an investment that is designed to provide a regular income stream with capital appreciation being secondary. Investors who use covered option writing as a core strategy have a different set of metrics when selling calls. They are keenly interested in seeing if the options implied volatility is compatible with their view of the underlying stock’s recent trading patterns. If so, does the option provide sufficient premium to justify buying the shares and selling the calls. Because the core writer is usually buying the shares and immediately selling the calls, liquidity is critical. Usually the close-to-the-money calls make the most sense because they are the most liquid and most closely reflect their fair value. The only other consideration for the core writer is time to expiration. We know with mathematical certainty that options lose most of their time value in the last three months prior to expiration. Time value erodes exponentially as the option gets closer to expiration. In short, core option writers should probably sell shorter term close-to-the-money options with less than ninety days to expiry.

Strategies for Income Investors seeking Yield

Income hungry investors continue to ramp up their risk appetite in order to collect extra basis points in yield. Bonds continue to defy gravity as foreign investors flock to the safety and higher yield in North American fixed income assets. Canadian bonds have turned in strong returns as witnessed by the iShares Broad Bond Universe (XBB) up better than 4% since the beginning of the year. There may even be more to come with sovereign debt issued by stronger European economies having slipped in negative territory. While it is difficult to imagine holding a security that guarantees to return you less money than you started with, these buyers believe the currency in which the sovereign debt is denominated will be stronger, which will more than make up for the negative yield. They may be right! With odds that Greece will exit the Eurozone and default on its obligations, there will be disruption in the Euro, which will inspire a flight to safety into stronger Eurozone partners and safe harbors like Canada and the US. The end result for Canadian investors; lower yields and higher prices for fixed income assets. The challenge for income seeking investors is that a higher price for fixed income assets means that the yield on these instruments will decline. And that does not take into account the punitive tax consequences for collecting interest income. Another approach is to look for equities that pay regular dividends. Dividends from preferred shares remain attractive although the value of many preferreds has not produced the kind of upside that we have seen with bonds. Most likely, because preferred shares are income producing equities where a missed dividend payment does not impact the corporations’ viability. A missed interest payment will force a company into bankruptcy. One preferred that I like is the Premium Income Preferred “A” (PIC.PR.A). This is a split share in a basket of major Canadian banks. The corporation buys a basket of Canadian banks and splits the potential growth (i.e. the capital share which owns the growth and dividend increases associated with the basket of banks) and an income stream (i.e. the preferred share which owns the preferential rights to the dividend stream paid by the bank basket). Think of the split shares this way; the capital share is a long term call option on the basket of banks while the preferred share is similar to a long term in-the-money covered call on the underlying banks. PIC.PR.A closed Friday at $15.36 and pays a quarterly dividend of .216 cents per share equal to a 5.63% yield. Since the underlying banks would have to fall precipitously for the in-the-money call to unravel, the yield is pretty safe. Keeping with that theme, you could implement a similar strategy by executing a longer term at-the-money call on a high quality dividend paying stock. Take BCE Inc. (BCE) as a case study. BCE pays a quarterly dividend of 65 cents per share which at current prices yields 4.82%. If you were to buy the shares at say $54.00 (Friday’s close $53.97) or better and write the January 54 calls, you would receive a premium of $2.15. For an income investor, this has appeal because the premium from the call option is taxed as a capital gain while the dividends receive preferential tax treatment via the dividend tax credit. The yield on this BCE covered call is 7.59% (annualized yield 10.30%) between now and the third week of January when the stock will most likely be called away. There is one caveat in that the BCE shares could be called away prior to the January expiration. That happens occasionally when selling in-the-money covered calls on stocks that pay above average dividends. However in this case that would simply mean that you earned your maximum profit early and could then enter a new in-the-money covered call using a longer term option.

Hedging a Diversified Portfolio

It is an accepted reality among investors that we are living in a global economy.  If you take a look at when most of the volatility in the equity markets has occurred, it is generally around a Bank of Canada (BOC), Federal Reserve Open Market Committee (FOMC) or an European Central Bank (ECB) rate announcement and subsequent press conference.  These kinds of risk are known as systematic risk and are based on broader geo-political and economic considerations.  The challenge is that it is difficult to hedge against this kind of broad based risk.  Many investors hold a diversified portfolio of companies representing different sectors. While this reduces the concentration of risk to any one specific market sector, there are times when there is no where to hide.  When an investor senses risk in any one stock, protective puts can be purchased to offset the potential loss.  Patrick offered some insight into this in his the post titled Have the Rail Stocks Been Derailed? This is known as unsystematic risk . This kind of risk can be managed with some cost effectiveness as puts need only be purchased on the individual stock.  The dilemma for the investor arises when there is concern for the entire portfolio in which case purchasing puts on all of the securities held may not be cost effective or even possible depending on options eligibility. I’ll be presenting at the Options Education Day in Vancouver on May 30th along with Patrick Ceresna, Richard Croft and Marty Kearny.  Click here for topics and registration details.  While there are a number of great topics lined up, my focus will be on “4 Ways To Hedge Against Risk”.  One of the approaches that I cover is the use of index options to hedge a diversified portfolio, more specifically SXO options. SXO options are priced based on the S&P/TSX 60.  For a complete overview of the contract specifications check out this Fact Sheet.  If the expectation is that a broad based market decline is going to impact the value of a diversified portfolio, rather then buying puts on each stock, the risk my be hedged by purchasing puts on the SXO.  As the broader market declines, the expectation is that the portfolio will drop in relation, the extent of which will be dependent upon the shares held in the portfolio and their weightings. In general, to calculate the number of SXO puts to purchase, the investor would use the following equation: Portfolio Value / (S&P/TSX 60 Value X $10.00), where $10.00 represents the standardized point value of the contract. This would offer the investor what is known as an imperfect hedge where a drop in the S&P/TSX 60 index may not be the exact same as a drop in the portfolio. To calculate the number of contracts that would more closely hedge the portfolio based on a drop in the index, the portfolio beta may be calculated.  The beta represents the amount of variance in the value of a portfolio comparative to the overall market. In this case, the S&P/TSX 60 is representing the “overall market”. With the beta of the index considered to be 1.00, a stock may have a beta higher or lower then 1 depending upon how correlated or uncorrelated it’s share price is with that of the market. You can calculate your portfolio beta by finding the beta of each stock, adding them up and then dividing that number by the number of shares in your portfolio.  If the shares have different weightings in your portfolio, you first multiply the beta by the weighting percent and then, execute the same calculation. To find the beta of a company, I use TMX Money and the “Get Quote” feature at the top of the homepage. Once this Beta number is established, the following equation would be applied: (Portfolio Value X Beta) / (S&P/TSX 60 Value X $10.00) One additional benefit of SXO options is that they are cash settled.  This means that the contract is settled for the difference between the strike price and the closing price of the index.  Rather than shares exchanging hands, if the option has any intrinsic value, it is deposited in to the investors account.  Comparatively, ETF and equity options are settled through the purchase and sale of the underlying shares.  For the investor who wishes to hedge the risk in their portfolio, but does not want to actually close any positions, this becomes an attractive solution.  As the portfolio value drops, the SXO option will offset a portion of the cash difference. Hedging is an important consideration in any investment plan.  Investors taking the initiative to manage their own capital need to be aware of the choices that they have to manage risk.  While the markets have continued to advance higher year over year, history has taught us that corrections are an inevitable part in the the stock market cycle.  By learning about SXO options and how to hedge a diversified portfolio, investors can be prepared to preserve their profits and protect their capital when market conditions change. For more information on portfolio hedging, please join us on May 30th for the Vancouver Options Education Day. For those of you that can’t make it, there are a number of videos available at www.m-x.tv to help you understand how to use SXO index options to meet a variety of objectives.

Have the Rail Stocks Been Derailed?

The past 4 years have been great for railway stocks.  The boom in energy and exportation of resources since 2011 has seen revenues and profits soaring.  Investors that participated in this story have been handsomely rewarded with stocks like Canadian Pacific Railway having risen 400% off of its 2011 lows.

While I do not want to question the quality of Canadian railway stocks, all investors must recognize that the easy money has already been made and what were cheap rail stocks in 2011 are now relatively fully priced stocks in 2015. While a stock being fully priced is not a concern in itself, we must factor in the fundamental shift in the macroeconomic environment.

So what has changed?  Oil.

The Canadian economy is resource based and has benefited from the growing infrastructure projects associated with fracking and oil sand production.  As production started increasing, oil producers increased their reliance on rail as pipelines failed to keep pace with the surge. Some suggest that this has been as much as a 40 fold increase in carloads in just 5 years.

The problem now lies in the fact that oil prices have collapsed.  The heavy bitumen oil produced from the oil sands has been particularly hit hard having recently dropped below $30.00.  While the companies have started to cut spending, the oil is still flowing.  The risk really is dependent on how long oil is to remain at or below these levels.  Production may have to be curtailed inevitably, impacting the pricing power and quantity of oil shipped.

The second problem lies in the recent derailment accidents.  There is now increasing government scrutiny which will lead to tighter regulations and increased costs as many railcars will need to be upgraded.

The bottom line is that there is increasing risk.  So should you sell your shares?  You could.  Should you buy a put option as protection?  You also could, but the cost is considerable if you are going out for a longer duration.  From my perspective, implementing a collar strategy makes the most sense as I believe there is still some upside (though limited).

Let me illustrate using Canadian Pacific Railway shares:

  • 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)
  • The collar is a combination of a protective put with a covered call.  In this case we are buying the October $230.00 put for $17.50 or $1750.00 debit for every 100 shares.
  • The investor then proceeds to sell an October $255.00 covered call for $7.50 or $750.00 credit.

The investor has now paid $10.00 or $1000.00 net for creating the collar.

What has the investor created?

The investor has created a scenario where they continue to enjoy the dividends and further upside of the stock up to $255.00.  At the same time, they have a put contract that guarantees them a sale price of $230.00 if the stock was to begin to weaken.  This gives the investor 6 months to see how the stock behaves.  In addition, the investor delays having to make the decision to sell therefore defers the capital gains obligations.  Considering the increasing question marks associated with the railway stocks, this is a great alternative for the investor that also allows them to sleep well at night knowing that if the bull market in railway stocks gets derailed, their profits and exit price have already been secured.

TD Bank Long Term Call Management

Back on January 30th, I posted a blog outlining a strategy to limit your risk for a longer term bullish position on TD Bank.  For full details please reference What About The Banks? I suggested that with TD shares trading at $51.00, we could purchase call options at the $52.50 strike price expiring in January 2016 for $2.99 per contract.

On February 13th, TSE:TD shares closed at $55.50 and the January 2016, $52.50 calls closed at $5.20 which represents a 73% return on your risk…had you locked in your profits at that point.

In all fairness, I was looking at this as a longer term proposition. The intention was to stay exposed to the potential upside of TD Bank shares, while limiting the capital outlay and risk exposure.  As a way to reduce the cost basis further, I suggested that in an unregistered account, we could sell near term calls against the longer term position.  I looked at writing the February $54 calls and collecting $0.20.  Since TSE:TD shares closed at $53.96 on the February expiration Friday, the $0.20 credit would be realized and the average cost of the position would be reduced to $2.79.

Now, following that approach, on Monday, February 23rd, The March $56 calls were bidding $0.26. Notice that with shares advancing in our favour, we have rolled the written contract strike up to $56.  It now gives us the potential for an extra $2.00 appreciation in the shares before having to consider making any adjustments or closing the position.  Our average cost basis at this point would be $2.53.

Since then, the shares have pulled back and currently trade at $53.20. There are now a few technical signs that indicate that we may see a continuation lower. For the novice technician, the easiest to identify is the break below the 200 day moving average as pictured below:

TD March 13

So we now have 2 choices:

1. Close the position:

The current value of the January 2016, 52.50 strike call is bidding $3.15.  We could close the position profitably, however we can’t forget about the March $56 calls we wrote.  They have to be bought back.  The current ask for this contract is $0.05.  We will basically be giving 5 cents of our 26 cent credit back.  This brings the average cost of the January 2016 $52.50 calls to approximately $2.58.  By closing this out today and moving to the sidelines, we would lock in 22%.

2.Buy a short term put:

If your intention is to hold the position for the duration, you can purchase a 1 month put option to hedge out any significant decline and possibly profit from a short term sell off. The April 52 strike put is asking $1.00.  By purchasing this short term protection, we would be basically creating a calendar strangle.  We are long the January 2016 $52.50 calls and long the April 2015 $52 puts.  Considering the credit collected from the short term calls writes, the addition of the protective put increases our average cost to $3.53.  If our expectation that the shares will reach $58.00 by January 2016 remains in tact,  this still offers the potential for a 56% return on our risk.  It is important to note that this will vary depending upon our option writing approach over the following months and whether the stock trades above our written strike in any given month. If the shares drop to $50.00 by the April expiration of the $52 puts, the put contracts will have an intrinsic value of $2.00.  With the original cost being $1.00, the additional $1.00 profit now further offsets the cost of your long term call.

Regardless of which approach to managing this trade we choose, we have a number of solutions at our disposal to make adjustments. By using options as a replacement strategy to owning the TSE:TD shares, we have had a limited risk exposure from the start. In addition, as the market conditions change and our outlook on a position is questioned we can be proactive with locking in profits or modifying our risk exposure.

A Eurozone Play

On January 15th, the Swiss National Bank (SNB - Switzerland’s central bank) removed its’ self-imposed restrictions on the Swiss Franc. A major shift in policy shrouded in secrecy at a time when central banks had been trying to be more transparent, which many felt would have dire consequences for the Swiss economy. Note the quote from Nick Hayden Chief Executive of Swatch a major Swiss exporter who opined at the time; “Today’s SNB action is a tsunami; for the export industry, for tourism, and finally for the entire country.”

The fallout from the SNB announcement was immediate. The Swiss Franc rallied 30% against the euro and companies like Swatch fell 16% as the cost of their goods destined for European buyers surged 30% in an instant. The Swiss stock market declined a precipitous 7% in one trading day.

Makes one wonder why a powerful central bank known for its conservative mind-set would appear to act so recklessly. It turns out that the SNB was caught between the proverbial rock and a hard place. It simply had no choice.

It was 2012 when the SNB initially pegged the value of the Swiss Franc at 1.20 to 1.00 euro. The self-imposed ceiling was intended to halt the Swiss Franc’s appreciation which was, among other things, causing problems for Swiss exporters. In hindsight, the January 15th SNB decision was a precursor to a €1.6 trillion bond buying program (i.e. quantitative easing or QE) announced by the European Central Bank (ECB).

As expected the euro immediately fell against the so-called safe have currencies such as the US dollar and of course the Swiss Franc. Clearly the SNB felt that it did not have the resources to defend its 1.20 to 1.00 euro peg against currency traders engaged in a flight to quality. Interestingly, all of this has taken place before the ECB has even begun printing the necessary euros to fund its’ bond buying endeavours.

Beyond the currency impact, I think the ECB has created an interesting opportunity. After two years of skirting the issue, the ECB has embarked on a program that will ultimately do what Mario Draghi has always said he would do; defend the Eurozone at any cost!

That is not to suggest that we will see a bump in Eurozone economic activity because, like the US experience, I suspect the ECB bond buying program will end up strengthening the balance sheets of European banks and probably light a fire under the various Eurozone stock markets by expanding P/E multiples and bolstering stock re-purchase programs.

To that point, traders are reminded of the 2013 rally in US stocks following the October 2012 announcement by the US Federal Reserve of QE-III. Since the ECB’s program is similar in size to QE-III, we may see some decent gains in European stocks during 2015.

The challenge is to take advantage of a surge in European stocks while hedging out the risk of a declining Euro. One product that comes to mind is the iShares MSCI EAFE Index ETF (symbol XIN, Friday’s close $24.48). XIN is not a pure play but it does provide exposure to European stocks and hedges the currency back to the Canadian dollar.

XIN has already rallied 9.97% since the beginning of the year but I think there is more to come. I note for example that money managers are warming to the idea of a stronger Eurozone in 2015. More than a few have opined that European stocks look relatively inexpensive when compared to the S&P 500 Index. And with the bond buying program just beginning, we should see it impact Eurozone stocks as the snow begins to melt.

Aggressive option traders might consider buying some longer term in-the-money calls to take advantage of this scenario. Specifically look at the XIN September 24 calls at $1.25.

Hedging the Currency Impact on Canadian Stocks

Canadian investors started the year with a pleasant surprise as the Canadian market and many Canadian stocks performed relatively well.  We suggest a little digression to understand the precipitating factors that have driven this rise.
Over the last 6 months, we have seen a dynamic shift in Canadian economics.  Canada has been relying heavily on the resource sectors to drive the wealth of the nation.  As the resource, particularly the energy sector, plummeted over the last half year, a number of significant concerns were exposed.  One only has to look to the Bank of Canada (BoC) and its significant shift in monetary policy to understand the need for immediate action to stabilize the situation. Without going into the specifics, the key observation that must be observed is the divergent monetary policy between the Federal Reserve and the BoC.  This divergence has been one of the key drivers in the substantial decline of the Canadian dollar. This currency trend has been significant enough to make a material impact on equity prices in the Canadian market.
In fact, one can attribute much of the rise in the Canadian stock market to the serious decline in the purchasing value of the Canadian dollar.  To give a few examples:

Canadian Market:

  • iShares MSCI Canada Index Fund ETF (US Dollars) – Year-to-date: -(2.30%)
  • ishares S&P/TSX 60 Index ETF (Canadian Dollars) – Year-to-date: +4.50%

BCE:

  • BCE shares traded in New York (US Dollars) – Year-to-date: - (3.78%)
  • BCE shares traded in Toronto (Canadian Dollars) – Year-to-date: +3.12%

If you are like the average Canadian investor, you are overweight Canadian equities in Canadian dollars and due to the decline in our dollar; we have seen a currency induced/adjusted advance in equities.  In order to remain strongly bullish Canadian equities, you have to believe in one of two themes.  One, there is a strong economic recovery around the corner for the Canadian economy, or two, the currency will still make a considerable decline towards $0.75 or $0.70 against the U.S.   If you are in one of those camps, you can stay long.  But if you believe the majority of the currency move is behind us and that the Canadian economy will struggle in the year ahead, this is a great time to employ yield enhancing strategies.
One yield enhancing strategy is to sell out-of-the-money covered calls for a longer duration like 6-12 months. These premiums allow you to create returns without needing further appreciation in the underlying stocks.  In addition, the premium received can act as a hedge to reduce the volatility of your portfolio.
As an example, the XIU – iShares S&P/TSX 60 Index ETF, is trading at $22.61.  That is over 10% higher off its $20.50 lows in January.  An investor that feels there is only marginal upside can sell a September $23.00 covered call is bidding $0.60 or 2.65% cash flow premium.
This is only a good idea for those investors that remain skeptical of the further upside of the Canadian market. At minimum, it is a strategy that could be actively deployed in the upcoming months once the market momentum has started to slow into the historically weak summer months.