What About The Banks?

Since my colleagues have already discussed Canadian Investors’ favorite topics, oil and gold (see Has Oil Bottomed? By Richard Croft and Is the Divergence in Gold and Opportunity? by Patrick Ceresna), I thought I would take a look at Canadian banks.

Canadian banks have no doubt come under pressure, dropping an average of 15% from the re-test of the 2014 highs, back in December, to their recent lows.  Most of this can be attributed to investor concerns over the fall out from declining oil prices. Concerns have been based on an expected disruption in several lines of business. This includes a decline in underwriting revenues, derivatives risk exposure and possible default in uninsured mortgages, home equity lines of credit and credit card payments in the oil producing provinces.

To add to the pressure, the Bank of Canada lowered interest rates by 25 basis points last week.  As a result, Canadian banks lowered their lending rates. The issue with this is that the banks rely on the spread between what they can borrow at versus what they can lend at.  As key interest rates drop, the spread tightens and profits suffer.  Interestingly enough, the 6 major banks only adjusted by 15 basis points in an effort to protect the already low lending margins. In addition, forecasts are pointing towards lower economic growth in 2015, which further adds “fuel to the fire”.

Investors have a habit of over compensating for the unknown.  While there are still many unknown variables, it does appear as though bank share prices in general may be stabilizing at these current levels.  Let’s take Toronto Dominion for example (TSE:TD). According to marketwatch.com, many analysts are rating TD as a buy and share prices appear to be finding some support at $50.00, which is a previously tested low.  As a side note, the charts look considerably different on the NYSE due to the currency consideration.  A factor that deserves significant attention as a Canadian investing in U.S. securities.

With TD earning due out on February 26th, we will see just what impact the lower oil prices and poor economic forecasts have had on the companies last quarter.

Many investors are motivated to own Canadian bank shares because of the stable dividend stream they provide.  However, with uncertainty looming, using a call option as a stock replacement strategy offers the investor the right to own the shares at these depressed prices with a limited risk exposure.  While the option buyer does not have the right to the dividend, it is important to note that dividends are already priced in to the value of the option. This actually reduces the cost of the contract from what it would be if the stock did not issue a dividend. In addition, the potential risk of holding the underlying shares may not initially be worth the 4% dividend yield.

With this in mind, we could look at purchasing a call option on Toronto Dominion (TSE:TD) ahead of the February earnings.  In this example, I want to look at holding a longer term position in TD into 2016.  This will allow me to benefit from any share appreciation over the year, but limit my risk exposure to a fixed amount during times of uncertainty.  If the shares take off at any point and are trading above the strike price I have selected, I have the right to take possession of the stock.

With TD shares trading at $51, we could purchase a call option at the $52 strike price expiring in January 2016 for $2.99 per contract.  This represents our maximum risk on the shares for almost an entire year.  It is important to note that our break-even point is $55 per share. This means that on expiration, the shares must be trading above $55 for the position to be profitable.  By using the option as a stock replacement strategy, we limit our risk on the shares to approximately 6%, when considering today’s prices. Compare this to an unidentified risk exposure for the out right share holder.

If, for example the shares finish the year at the previous high of $58.00, the option would have an intrinsic value of $6.00.  This is determined by subtracting the strike price of the option ($52) from the settlement value of the stock ($58).  This reflects a 100% return on risk.

For the income focused investor, outside of your registered accounts, you can implement the calendar spread strategy.  While holding the longer term call option, you can sell out-of the-money calls to generate a monthly cash flow as you would in a covered call strategy.

For example, while holding the January 2016, $52 strike call, you could sell the February $54 strike call for $0.20.  If you can collect this kind of premium on a regular basis, you will significantly lower the average cost of your longer term option and subsequently reduce your break even point on the shares.

The trade off with this approach is that if the shares jump beyond the written strike, you may be assigned to deliver them.  In the example above, as the stock approached $54, the investor may be motivated to buy the written call back and roll the position by selling a call at a higher strike and further out expiration date.

If you are interested in owning TD at these levels, consider the longer term call option purchase as way to gain exposure with a limited and identifiable risk for almost an entire year.  Of course if shares continue lower the option always be sold for a partial loss rather than holding out until expiration and risking the option expiring worthless.

Regardless of how you manage or modify the position, the longer term call option offers the investor the ability to take a decisive stance on a stock and weather some of the short term uncertainty with a limited and identifiable risk exposure.

Has Oil Bottomed?

Trading in the first quarter of 2015 will center on oil for good reasons. Not only has oil’s fall created one of the largest tax cuts since Reaganomics, the fallout has far reaching implications across a broad spectrum of industries.

Interestingly, at US $105 per barrel, it was obvious to anyone who understood supply and demand that oil was overvalued and demand will not likely drive oil prices higher as it is at best, stable with a slow bias to the upside.

Supply on the other hand has been rising at an almost exponential pace. Particularly as fracking technology has allowed the US to get at supplies that were previously unattainable. There is a view that U.S. and Canadian operations may be taken off stream as prices continue to decline. At present, most of the major wells remain in play likely because the estimated cost of production is somewhere between US $30 and US $45 per barrel. This is not as profitable based on recent prices, but margins that are sufficient to maintain current drilling operations.

The question is where do we find a bottom? My best guess is that we may have already put in a bottom and will likely trade in a range between US $40 and US $60 per barrel throughout 2015.

The one view everyone seems to share is that oil price declines benefit consumers. Perhaps, but those benefits seem to have been misplaced as consumers were reluctant to spend over the holiday season. Is it possible that consumers in the US and Canada have developed a savings habit?

We also know that a disruption within any sector leads to a domino effect across the economy often with unpredictable consequences! For example, we know that the Russian economy is imploding. That’s a dangerous environment when you have powerful politicians seeking to retain power in a declining economy that has no safety nets.

Veteran traders may recall April 2nd, 1982 when Argentina laid claim to the Falkland Islands, ultimately sparking a ten week war with the United Kingdom. The Falkland War was not about claiming territory in the South Atlantic, it was about deflecting attention away from the hyper-inflation that lead to rioting and civil unrest within Argentina. In the end, Argentina suffered a major defeat on the battlefield but got its desired result by focusing the country’s attention on the war effort and away from domestic problems. I am not suggesting that Russia will engage in the same kind of mind games,but you have to think that Ukraine is a potential pawn should things worsen.

The same story is true in Venezuela, that has already imploded and will most certainly face civil uprisings. More importantly, the Middle East, where major producers like Saudi Arabia have enormous fixed costs that cannot be honored unless the country continues its current output regardless of the longer term consequences!

On the positive side, we have seen movements in Iran away from their nuclear ambitions, which is clearly driven by their desire to further the domestic agenda in an environment of lower oil prices. In fact, we may see a politically motivated agreement forged in the months ahead that only six months ago would have been impossible.

On an economic level, there is no doubt that oil producing regions of the US will suffer as will the Canadian economy given oil’s roles as one of the three pillars that drive Canadian GDP. However, it may not matter much when you consider the power that oil wields on the political stage.

Oil is one of the world’s great equalizers. Long employed by oil producing countries to influence their political agenda, I suspect the US will be reluctant to ratchet down production for fear of losing a big stick.

When you think about it in those terms, it is clear that the US has been wielding a big oil stick with some clear results. As mentioned, Russia is imploding based on the fall of the Ruble, Venezuela’s economy is on the verge of collapse and the OPEC countries no longer have any real influence on the world markets.

Same goes for the US fight against terrorism. The best way to stop a radicalized fringe groups is to stop funding them. As North America becomes less dependent on foreign oil, it creates an interesting political backdrop to enact these types of policies.

If we accept the twin premise that oil has 1) put in a bottom and 2) is unlikely to rise sharply during 2015, traders may want to look closely at covered call writing on some of the larger energy names. The recent volatility that has sent option premiums higher across the energy sector make this strategy especially appealing.

Some stocks to consider as covered writing candidates; Crescent Point Energy (Symbol: CPQ, Friday’s close $30.07). Selling the April $32 calls at $1.65, Canadian Natural Resources (CNQ, $35.51), selling the May $36 calls at $2.90 and Imperial Oil (IMO, $47.43) selling the May $48 calls at $3.20.

Is the Divergence in Gold an Opportunity?

Gold has drawn my attention this month, not just because of the rise, but the conditions from which the rise is occurring.  I pride myself on being a student of intermarket relationships within the markets.  One of the key pillars of intermarket analysis is the understanding of the inverse correlation of the U.S. Dollar to commodities.   This could not have played out in a more clear way in the second half of 2014.  July 2014 marked the bullish breakout of the U.S. Dollar and marked key commodity downturns in oil, copper, uranium, iron ore, gold and many other commodities. This marked a distinct bear market drive in almost all commodity based stocks.

As the U.S. Dollar rose throughout the second half of 2014, gold declined $200.00 an ounce from $1340.00 down to a low below $1150.00.  But the New Year has brought about an interesting divergence.  Driven by 1000 pip ($0.10) drop in the Euro, the U.S. Dollar has been very strong to start the year.  This has caused a further $10.00 decline in oil prices and a $0.40 further decline in copper prices.  With all things considered, the correlation in gold would have naturally allowed it to weaken down to the $1100.00 area.  But it didn’t.

Instead we have seen gold stabilize and bullishly advance over $100.00 an ounce over that timeframe.  These types of divergences draw my attention.  This implies to me that the uncertainty in regards to a global recession and new ECB quantitative easing policies is drawing attention to gold as a hedge.  As we now see zero to negative interest rates in the stable parts of Europe, holding 0% yielding gold bullion is a viable asset to hedge currency risk.

It is premature to be hyping a new gold bull market, but with gold and gold stocks being so depressed over the last 3 years, there may be room for them to retrace some of the overdone selling.  The traditional way for investors and traders to participate in a trade like this is to buy a gold ETF like the iShares Gold Bullion ETF (CGL) and/or the iShares S&P/TSX Global Gold Index ETF (XGD).  My observation as a trader is that the ETFs alone do not make the trade asymmetric enough.  This is where I like to consider an in-the-money call option as a high delta way to participate.

Let’s compare the purchase of shares vs. call options with a $4.00 rise in the XGD stock.

  • 1st investor buys 1000 shares of the XGD for $11.34 or $11,340.00 investment.  The investor has an undefined downside risk if the trade idea is wrong.   If the stock was to rise to $15.34, the investor would be sitting on $4,000.00 in paper profits.
  • 2nd investor buys 10 March $10.00 call options for $1.57 or $1,570.00 which gives the investor the right to buy 1000 shares over the next 2 months at $10.00 per share.  If wrong, unlike the undefined risk of the stock investor, the absolute worst loss the investor can incur is $1570.00.  If the stock was to rise to $15.34, the call would have a $5.34 intrinsic value. This would be a $3.77 profit per share or $3,770.00.

Many traders like to look at the option trade as a 200% gain, but I don’t look at it that way.  I look at it from the perspective that I was able to get an almost dollar for dollar participation (high delta), while being able to manage and define my risk.  In March, the investor has the choice to take profits or to exercise the calls and take ownership of the ETF for the long term.  To me, this represents a compelling alternative to just buying the stock.

Weekly Options Now Available in Canada

I had the pleasure of presenting at the Toronto Options Education Day back on September 27th, 2014.  The topic was “A Guide To Weekly Options”.  Even though the contracts had yet to launch the interest was overwhelming and many traders and investors have been patiently waiting to access this new product since then.

Well the wait is over, the Montreal Exchange has officially launched weekly options on the following stocks:

  • Barrick Gold Corporation (ABX)
  • Blackberry Ltd (BB)
  • Encana Corp (ECA)
  • Goldcorp Inc (G)
  • Ishares S&P/TSX 60 index ETF (XIU)
  • Potash Corp of Saskatchewan (POT)
  • Royal Bank of Canada (RY)
  • Suncor Energy Inc (SU)
  • Toronto Dominion Bank (TD)
  • Yamana Gold (YRI)
These options have the same contract specifications as a standardized monthly contract except that they are introduced on a Thursday and trade through to the close of the Friday of the following week. The main difference between Canadian weekly options and U.S. Weeklies is that only 1 Canadian weekly can be listed at any time unlike U.S. Weeklies which allow up to 5.
With this in mind, Canadian weekly options offer traders and investors a new approach to meeting their objectives.

Benefits include:
  • More choice for spreads and combinations
  • Cheaper premiums for greater short term leverage
  • More sensitivity to stock price movements for short term traders
  • Target specific events without having to purchase more time than needed
  • Protect positions against earnings by purchasing 1 week of protection versus one month
  • Enhanced cash flow for option writers with 52 expiration dates per year
Challenges may include:
  • Requirement of active management based on short term objectives
  • Little time to make adjustments due to accelerated rate of time depreciation
  • Less up front premium for the option writer
  • May be more commission intensive
Individual traders and investors will have to determine for themselves how, if at all, weekly options will fit into their plan.  I am not personally a “short term” options trader however I see significant opportunity in using these weekly options as part of an income strategy.
Income Generation
Using weekly options as part of a Covered Call strategy presents an opportunity to take advantage of the rapid time depreciation associated with a short term option contract.  This also allows the investor to evaluate expectations on the stocks performance over a short period of time and make adjustments accordingly.
Below is an example of Barrick Gold Corporation (TSE:ABX).  The important consideration is to compare the annualized rate of return for each option write.

Barrick Gold Corporation (TSE:ABX) shares at $13.21, 14 strike call write:
ABX Weekly Comparison

Observations
While the longer term option writes deliver greater up front premium and are less transactional, the annualized rate of return is lower than the weekly write.  With that in mind, the weekly option provides enhanced cash flow over the long term but offers less upfront premium.  In a primary bullish market, this may be a good trade off. However, if there is an expectation that the market may be volatile (to the down side) collecting more premium up front to mitigate the anticipated market volatility may be the best solution.

The bottom line is that weekly options have unique characteristics that make them a viable solution in certain situations.  It is up to the investor to determine where they fit into their plan.  I believe the more tools we have at our disposal, the more effective we can be as retail investors in navigating these markets. For more information on weekly options available on Canadian stocks visit MX Products>Weekly Options

Using Stock Cycles For Covered Call Writing

As a Chartered Market Technician I spend considerable time exploring the quantitative side of stock and broader market cycles to find periods of statistical advantage. For investors it is often simply trying to maximize the returns from a longer term holding. I have found that there is considerable value in enhancing investment yields through periodically and passively implementing covered calls.

Key tenants to this methodology are the open acceptance that stocks do not just go up in a straight line, but rather go through cycles of overbought and oversold conditions. If that can be openly accepted, then it becomes about identifying a measuring technique to quantify that cycle.

To illustrate, I will use BCE shares. BCE has been in a decisive bull market from its 2008 low of $16.85 to its current test of multi-year highs. A disciplined and patient investor has been well rewarded with a material capital gain and a consistently lucrative dividend income stream. But when one looks deeper into the cycles, investors may see value to seeking to enhance that return.

On the table below I simply identified where the stock price was relative to its 52 week mean average. What is identified is that over the last 5 years BCE has had 7 intermediate swing highs that, on average, occurred when BCE was trading $5.00 above its 52 week mean price. Each of these 7 periods the stock proceeded to consolidate lower or sideways an average of 185 days (6 months).

If an investor was to believe that there is statistical merit to that observation, then selling covered calls on the stock when it has reached an overextend state would enhance the yield income on a stock with limited short term upside potential.

Last week on November 21st, BCE had a closing price at $54.24, which was $5.96 above its $48.28 52 week mean price. Referencing the 7 past cycles, this suggests that BCE may be close to the upside of its current rise and there may be increasing value in writing a covered call at these levels.

  • At the time of writing (Nov 26, 2014), BCE is trading at $52.88
  • May $54.00 covered call is bidding $1.05 (1.99% cash flow)
  • May $56.00 covered call is bidding $0.50 (0.95% cash flow)

For an investor that owns BCE for the current 4.67% dividend income stream, selling a strategic covered call gives the potential to enhance that income to 5.50-6.50%. While there is no guarantee the stock cannot go higher and exceed the call strikes, an investor that looks at the probability associated with the rise may recognize it is far more probable that the stock consolidates after such a substantial rise. If a covered call was strategically written at each of these 7 prior peaks, the investor could have collected 5-15% addition income over the last 5 years.

Using options is an active strategy, that may involve having to sell the stock or buy back the option which makes the strategy more dynamic. But for an investor willing to be more active, the additional income may be worth the effort.

A Year End Rally?

We have a short week of trading in light of US thanksgiving. Just enough time to position your portfolio for a year-end rally?

A year-end pop seems to be the consensus opinion among the largest US hedge funds. Mind you that may be hype or at a minimum wishful thinking. Fact is many large hedge funds have under performed a passive and much less costly investment in the S&P 500 composite index. They will need a year-end rally in order to justify their fees.

While I tend to discount the blather that comes from the hedge fund community I think this time they may be right. Consider the macro picture; the decline in the price of oil has given US consumers a massive tax cut coming into Black Friday. If history is any guide that should lead to a boost in spending. With two thirds of US GDP dependent on consumer spending that may well push year over year US GDP above 3%.

If you buy into the premise of a strengthening US economy, Canadian investors must be aware of the impact on currencies. If oil prices continue to decline and if the European Central Bank and Japan central bank resume their quantitative easing programs, the US dollar will rally into the new year. Now Canada will be hedged somewhat as we will ride the coat tails of the stronger US economy. But the decline in oil prices will prevent any rally in the Canadian dollar. At best the loonie will track the US dollar although it is more likely that it will decline slightly in the months ahead.

The easiest way to play this US story is to buy a non-hedged S&P 500 ETF. The Vanguard S&P 500 ETF (TSX: VFV) comes to mind.

Another consideration for Canadian investors is how this playbook will impact commodity prices; particularly gold. A higher US dollar would slow any rise in gold and gold stocks especially if there is little evidence of inflation.

My trade here is to execute a bear call spread on a Canadian gold stock such as Goldcorp (TSX: G). Goldcorp recently traded at $23.20. Look at writing the Goldcorp December 24 calls around 70 cents while buying the Goldcorp December 27 calls at 15 cents. This will produce 55 cents net credit which if I am right should expire worthless at the December expiration.

Options Combinations to Reduce Risk

One of the true benefits of understanding the complexities of the options market is the ability to construct strategies that help meet any number of trading and investment objectives. Often times novice option enthusiasts are intimidated by multi-leg combinations because of the number of “moving parts”.  For those of you that are not sure what I mean by “multi-leg” this term simply refers to a strategy that is constructed of the purchase and or sale of different option contracts.

In order to understand any multi-leg strategy, we first need to have a solid grasp of the rights and obligations associated with being an option buyer versus an option writer.  There are a number of videos at M-X.TV that can help you with this; however a review of the Introduction to Options trading video should cover all the details necessary.

For the purpose of this blog post, I want to look at constructing a 4-legged strategy known as a Directional Condor.  It is important to realize that any complex strategy is simply a combination of multiple “simpler” strategies. By dissecting the components, the novice option trader can begin understand why a certain advanced combination may be appropriate.  In addition, by understanding the rights and obligations associated with the various components any limitations to the strategy can be identified and the trader can manage performance expectations accordingly.

A Directional Condor may be applied when the trader has an expectation that a stock is going to move in a particular direction, but is not likely to exceed a certain price range within a specified period of time. The Directional Condor is simply a combination of a Debit Spread and a Credit Spread.  Check out these videos for a more detailed description of the strategies and examples of how they may be applied independent of one another.  Bullish Spread Strategies and Bearish Spread Strategies and further to these, Defining Option Spreads

The Debit Spread is used to trade the directional bias.  The trader incurs a cost but may want to further offset this cost.  By selling a Credit Spread further out of the money, but with the same expiration date, a credit is received and the net cost of the position is reduced.  This lowers the break-even point of the trade and increases the percentage rate of return should the investor be correct in their forecast.  The “trade-off” is that in order to achieve maximum profitability, the stock needs to be trading between the written strikes of the Debit Spread and the Credit Spread on expiration.

Take a look at the daily chart on Blackberry Lmt (TSE:BB) below as an example:

bb conder

4 Legs, 2 Strategies

As I mentioned, the more complex strategy is simply a combination of two, less complex strategies.  By breaking it down this way, it becomes easier to understand the logistics if the trade, and more importantly how to execute it within you brokerage platform.

condor

For the purpose of this example, we will use options expiring in January 2015.  As of November 12th, 2014 the prices of the option contracts were as follows

January, 13 strike Call -  $1.10 Buy
January, 14 strike Call -  $0.70 Sell
January, 15 strike Call -  $0.50 Sell
January, 16 strike Call -  $0.30 Buy

The net cost of the Condor is $0.20/per share.  This represents the maximum risk of the trade regardless of what happens with the stock.

The Maximum profit is the difference between the 13 and 14 strikes which is $1.00 minus the cost of the trade which is $0.20.  This results in a profit potential of $0.80.

There are 2 break even points on expiration because of the combination of Debit and Credit Spreads
Break even #1 is the 13 strike purchased plus the cost which equals $13.20
Break even #2 is the 16 strike purchased minus the cost which equals $15.80

Maximum profit is achieved when the stock is trading between $14.00 and $15.00 on expiration.  This would represent a 400% return on risk.  Remember that you can close the position in its entirety or “Leg Out” which means off set a portion of the combination at any point before expiration to lock in profits or manage risk.

While the Condor has a limited profit potential, the multi-legged combination offers a very attractive risk/reward opportunity if the trader feels that the stock is not likely to trade beyond a certain range within a specified time frame.

Irrefutable Testament To The Value of Put Protection

First off I wanted to say thank you to all the Toronto Options Education Day attendees for a warm welcome, it was a pleasure to meet all of you.  Recently the stock markets have increasingly become volatile as almost all Canadian sectors have gone through a healthy profit taking cycle.  This gives us the opportunity to reference back to our prior blogs where we demonstrated the use of puts as protection.

For those who are new to put options - every 1 put option purchased on a stock represents a contractual right to be able to sell 100 shares of a stock at a specific price over a specific period of time.  When used as protection for investors owning stocks, it offers the ability to create certainties in an ambiguous market.

Looking back to August 29th.  I wrote a blog titled “Is there any Fuel Left in the Energy Sector Bull Advance?” In that blog we referenced the substantial divergence between the price of crude oil (and natural gas) in relation to the material advance in energy stocks. I felt this created an increasing vulnerability to owning the shares and presented an example using Imperial Oil(TSX:IMO).

We could not have been more right.  The time of the blog marked the highest price Imperial Oil traded before a substantial decline of over 15% (close to $10.00 a share). In that example we purchased an October $56.00 put option (secured the guaranteed sale price of $56.00 for the shares).  I wanted to demonstrate the value the insured investor received vs. the traditional buy and hold investor.

Investor 1 - Buy and Hold

In this example the investor owned 1000 shares at an average cost of $45.00. At the time of the blog the stock closed at $57.50 which saw the investor up 28% in paper profits.  On October 17th the stock closed at $51.45 which saw the investor lose half the profit down to 14%.

Investor 2 - Bought the October $56.00 put as protection

In this example the investor owned 1000 shares at an average cost of $45.00.  The investor was also up 28% in paper profits on August 29th but that investor spent the $0.75 to buy the October $56.00 put protection.  On the October 17th options expiration the put option was $4.55 in-the-money ($56.00-$51.45).  This allowed the investor to close the put at a net $3.80 gain ($4.55 - $0.75 cost).  The gain on the put allows the investor to have a new adjusted average cost on the shares of $41.20 ($45.00 - $3.80).  This means that at the $51.45 closing price and a $41.20 new average cost, the investor is still up 25% on the stock, in spite of a violent $10.00 decline from top to bottom in the 2 months of the trade.

The key take away is the investor protected themselves, managed risk, locked in gains and substantially reduced the volatility of their portfolio.  Who says options are risky now?

In my opinion, investors taking the time to educate themselves on options as an investment tool is one the single most important things one can do to improve the chances of long term success.

Cheap Isn’t Always Better

I’ll be traveling to Winnipeg today on behalf of the Exchange to facilitate a workshop for aspiring, active investors.  I have had the opportunity to present to this group on several occasions and despite the anticipated cold weather, I know the crowd is always warm, very interactive and hungry to learn.

That said, one of the topics I will be focusing on will be options trading mistakes to avoid. I always think that this is a great topic, because regardless of how well you understand the basic trading principles of using options, it’s good to be reminded of some of the pitfalls that stand between you and trading and investing with options successfully.

While there are many common mistakes (I cover 10 in my presentation) I want to focus on one that proved to be an expensive misunderstanding for me when I first started options trading. In fact, if you are interested in the entire breakdown of the the most common mistakes, check out this video found at M-X.TV
Avoid The 10 Most Common Option Trading Mistakes

The Misconception

There tends to be a misconception that buying cheap options is the best way to leverage capital and a surefire way to guarantee a home run on a stock that is expected to make a substantial move.

While it is true that options offer a trader the ability to substantially leverage their capital with a limited and identifiable risk, it is important to understand that options are cheap for a reason. Often time’s novice traders overestimate their probabilities of being correct and underestimate their risk.

It’s all about the probabilities

I am going to assume that readers already have a basic understanding of terms such as strike price and expiration date as they relate to the options market.  If not, here is a link to an Introduction To Option Trading video.

In order to truly understand the importance of probabilities, aspiring option traders must recognize that options are priced based on the expectation of whether a stock has the potential to trade beyond the selected options strike price within a specified time frame.

For example, let’s take a look at call options on Blackberry Limited (TSX:BB) Currently the shares are trading at $11.70.

To look at it from the perspective of time:

Note that the more time allocated for the stock to move towards and beyond $12.00, the more expensive the option contract. This is because the market is pricing in the stock’s average Historical Volatility.

Historical Volatility is the amount that a stocks share price has been fluctuating over a period of time.  For more information on volatility check out out Patrick’s blog Trading Volatility. The price of the November contract is suggesting that there is a moderate chance that shares of BB are going to trade above $12.00 by the November expiration based on its historical trading behavior.  Not a good bet in my books.  By allocating more time, the trader has a higher probability of being correct. Remember, if the move happens in a day, you can still close your longer term option out for a profit. However if the move happens over a 3 month period, the November option will be long expired and a full loss potentially realized.

Because we are focused on trading shorter term price movements on volatile stocks, we tend to focus on selecting 2-3 months out for our expiration dates. This is with the expectation that we are likely going to be out of the position within 1 or 2 weeks.  Despite the fact that we have a shorter term outlook, we realize that our anticipated price move may not happen immediately.  By allocating more time than anticipated we believe we are “erring on the side of caution”

You also don’t want to purchase too much time either.  As a general rule, slower moving stocks need to be given more time for the price to reach the anticipated level.  You also must consider whether you are an active trader with a short term outlook or whether you are more passive and have a longer outlook.

Rule of thumb

Know the stock you are trading options on, determine your outlook, select the appropriate time frame and manage the position accordingly.  And when in doubt GIVE YOURSELF A LITTLE MORE TIME!

As for my lesson

I did all of the research, analyzed the price chart and was confident the stock was going to move.  I wanted to get the best bang for my buck so I chose a cheap, short term option.  Long story short…I was right about the stock but wrong about the time I selected for my option contract.  1 month passed, my option expired worthless and then the stock took off as anticipated. In hindsight, I could have purchased fewer contracts but with more time. This would have tipped the probabilities of being correct more in my favor and allowed me to profit from my original outlook.

Remember, learning to trade and invest with options is an ongoing journey and we learn from our mistakes. Be sure to analyze your losses to see if you took all things into consideration.  We are dealing in a business of probabilities, so if we can filter out mistakes such as the one discussed here, we tip the odds a little more in our favor.

Options Education Day 2014 - Toronto Final Presentation