If investors believed the euro-mess were a threat to the global financial system, you’d expect the price of gold – the ultimate crisis hedge – to be probing new highs about now. Instead, the yellow metal is being sold off, and funds are flowing torrentially into US dollar Treasury assets, strengthening the US dollar. Nearby contract gold futures dropped another 4.4% last Thursday, the largest percentage decline in 14 months. To date, the precious metal has retreated 12% from its December high of US$1,214 per ounce.

Crude oil likewise dropped below US$70 per barrel as huge inventories continue to hang over the market (95 days’ supply compared with an average of 86 days), OPEC capacity increases, and demand remains soft. Oil futures are down nearly 8% this year, while copper, often referred to as “Dr. Copper” for its predictive value, is down 14%, also on rising stockpiles with no concomitant increase in demand.

Some analysts believe that commodities are in fact significantly overpriced and poised for a major correction. The entry of exchange-traded funds using derivatives as proxies for commodity holdings have changed the commodity landscape. ETF money is intensely volatile in a sector where extreme volatility is already the watchword. If very large long institutional positions are liquidated (say by one or two hedge funds), a momentum-driven correction could result as hot money charges away from commodity ETFs.

For aggressive options traders, this could present a profit opportunity with bearish positions in large, liquid, optionable commodity-based exchange-traded funds. This could include Canadian-based ETFs like the iShares CDN Materials Sector Index Fund (TSX: XMA, recent price $16.93). Look at buying the March 16 puts at 40 cents.

You might also consider hedging your bets with larger mining companies, especially copper miners, like Teck Resources Ltd. (TSX: TCK.A, recent price $34.20).

With TECK, which has some rich option premiums, you might want to look at writing the May 34 covered calls at $3.80 (assuming you own the stock).

If you don’t look at Teck bear call spreads, where you write the March 34 calls at $2.70 and buy the March 42 calls at 45 cents. Net credit for this trade is $2.25 per share, which you will keep if Teck is below $34 at the March expiration.

The MX Implied Volatility Index (symbol: MVX, Friday’s close 19.38) spiked last week in reaction to weakness in the global markets. And there may be more to come.

A number of technical analysts have raised a red flag as the S&P 500 Composite Index broke support at 1085. It closed Friday at 1073.87.

Among fundamental analysts, earnings are center stage. And while better than expected, are not exciting investors. Mostly because there is concern about whether earnings are sustainable once stimulus measures are lifted. It is not about what you did for me, but what are you going to do for me?

Rumors about more problems in the banking sector surfaced on the week end. On the heels of US government attempts to rein in excessive bonus pools, there are now concerns about the health of UBS. Could we once again test the “too big to fail” doctrine?

Globally, China is reining in credit in an effort to manage their double digit growth. And Greece is looking for ways to keep creditors off their door step.

All in all a pretty compelling bear case; 1) higher option premiums, 2) bearish vibes from technical and fundamental analysts at the same time and, 3) sentiment driven by fresh rumors from the banking sector and 4) global uncertainties.

Having said that, you need to be cognizant of the fact that markets rarely do what the majority thinks they will do. Which means that this bear case may be nothing more than a short-term blip.

Even so, option traders have the ability to hedge against blips, which if successful, help you smooth out some of the bumps in your portfolio. Especially if you are predisposed to keeping your current equity positions.

At the top of the hedge list, you might consider writing short-term, at- or in-the-money covered calls on stocks you own. Or even buying puts to protect some of your positions.

Another approach is to sell bear call spreads. For example, with Research in Motion (symbol: RIM, recent price $67.47), you could sell the RIM February 68 calls and buy the RIM Feb 74 calls. For $1.50 per share credit. If RIM stays below $68 per share until the February expiration, you pocket the net credit. Your worst case would see RIM rally above $74 per share, in which case you would lose the maximum $6.00 per share (the $6 per share represents the difference in the two strike prices) less the $1.50 net credit which equals $4.50 per share.

With Bank of Montreal (BMO, recent price $52.00), you could write the Feb 52 calls at $1.00 and buy the Feb 54 calls at 25 cents. Maximum profit is the net credit of 75 cents while the maximum risk is $2 per share less the 75 cent net credit.

Potash Corp. of Saskatchewan Inc. (POT, recent price $105.92) is another potential candidate. Writing the POT Feb 105 calls at $5.00 and buying the Feb 115 calls at $1.50. Maximum return is the $3.50 net credit, maximum risk is $10 per share less the net credit ($3.50) or $6.50 per share.

Psychologically, bear strategies are difficult to implement. Most traders are bullish, and if they are holding for the long term, want to see their portfolio escalate in value. And the portfolio might! Perhaps in the second or third quarter. But at this stage, there is a real possibility of a bear trap. And hedging against a bear trap seems to make a lot of sense.

A recent query (from M. Heng) about a recommendation I made on BNN on November 20th. I recommended buying CurrencyShares Canadian Dollar Trust (symbol FXC) as a play on the US dollar. FXC is effectively an exchange-traded fund that rises or falls in line with the performance of the Canadian dollar vis-à-vis the US dollar.

We were short for time on that particular segment, which quite frankly, is an issue anytime you are dealing with thirty second sound bites. On the Nov. 20th show, I suggested that FXC would rise if the US dollar continued to decline. Which is correct. But, since FXC is traded in US dollars, any increase or decrease in value has no benefit for a Canadian investor. That should have been said, and had time permitted, would have been.

What I also wanted to say – had time permitted – was the fact that FXC was a tool to hedge against the currency risk associated with US holdings. For example, say you owned US $10,000 worth of SPY (S&P 500 Depositary Receipts). SPY, of course, trades in US dollars. If SPY rallied 10%, your investment would be worth US $11,000. But what happens if over the same period, the Canadian dollar also rallied by 10%. When you convert your US dollar investments back into Canadian dollars, you gain nothing. And there lies the value of hedging.

In the SPY example, you could hedge against the risk of currency fluctuations by buying US $10,000 worth of FXC. A 10% rally in the Canadian dollar would push up the value of FXC by 10%. When you combine the returns of FXC and SPY you end up with a 10% net return over the holding period.

Of course the cost of purchasing the FXC exchange-traded fund outright, overshadows the benefits of the hedge. A better approach would be to buy FXC calls and sell FXC puts at the same strike price. The premium received from the put should offset the cost of the call which means no out of pocket cash is committed to the hedge.

Because a long FXC call / short FXC put combination is equivalent to a long futures contract on the Canadian dollar, that’s typically the approach institutional investors take when trying to hedge currency risk.

Coming full circle we arrive at USX which is a currency option that trades on the Montreal Exchange. USX allows you to profit on your outlook for the US dollar vis a vis the Canadian dollar. In this case, the options are traded in Canadian dollars and the underlying currency is US dollars. The exact opposite of FXC and the only way for Canadian investors to profit from a shift in exchange rates.
Sticking with USX which trades in Canadian dollars, you would buy USX calls if you thought the US dollar was set to rise against the Canadian dollar. If you believe the Canadian dollar will rise against the US dollar, USX would decline and a long USX put position would profit.

The program for the Options Education Day to be held in Toronto on March 13, 2010 is now available. For more information, click here.

In a word, consumer staples stocks are “h-o-t”. These are companies that make or sell food, beverages, and essential “staple” items that consumers must have regardless of the state of the economy. Since the end of October, the S&P/TSX Capped Consumer Staples Index has advanced 10%.

And the fundamentals underpinning that advance seem solid. The stronger companies in this sector managed some aggressive cost cutting over the past two years. And with the economy looking healthier, revenues should jump in 2010. The combination of aggressive cost cutting and growing revenues means increased margins. Which is to say, solid profit growth which is what drives stock prices.

In Canada, there are no ETFs that focus specifically on consumer staples. As such, aggressive option traders who believe that consumer staples stocks are just beginning their run, need to look at strategies on individual companies.

Consider for example, buying calls on liquid optionable stocks like Loblaw Cos. (TSX: L), George Weston Ltd. (TSX: WN), and Shoppers Drug Mart Corp. (TSX: SC). With premiums continuing to decline (note the MX Implied Volatility Index closed Friday at 18.45%, which marks a 52-week low), option buying strategies offer better risk reward characteristics on sectors where we are anticipating growth.

With Loblaw Cos., you might look at the July 36 calls currently at $1.00 (implied volatility 18.92%). George Weston Ltd. July 72 calls at $4.00 (IV 22.03%) look interesting as do the Shoppers Drug Mart Corp. July 46 calls at $1.70 (IV 17.30%).

We’re on blog vacation for the next three weeks (back on Jan. 11, 2010). Warmest thoughts and best wishes from all of us at optionmatters.ca!

Canada’s forest products and forestry industries have been in the dumps for so long that the only place to go is up. And that’s exactly what’s been happening over the past few months. The driver behind the resurgence in the forest products sector has been the anticipation of the end of the recession and a recovery in demand for building materials as the housing market bottoms.

What’s given the sector some extra juice recently is a change in building-code policy in China following several highly destructive natural catastrophes over the past couple of years. The change involves a break in the near-monopoly that concrete fabricators enjoyed in building standards. Concrete-frame structures are not nearly as flexible as wood-frame structures in earthquake-prone regions. Heavy reliance on concrete as a building material usually results in catastrophic loss of life and property damage during episodes of severe earthquake.

A change in building codes in China will lead to greater demand for lumber as a building material. And because China has very little of its own forestry resources, it must import much of its lumber. Enter Canada, which when seen from a satellite, consists mostly of forests. Canadian forestry and forest-product companies are thus poised for continued robust growth into the foreseeable future, if only because of the injection of huge new Chinese demand.

After languishing for so long, Canadian forest products companies have a lot of ground to regain. As the recovery moves forward, there may be an opportunity to capture some of the potential upside in this sector.

The easiest strategy is to buy calls on companies like Canfor Corp. (TSX: CFP, recent price: $7.51) or Sino-Forest Corp. (TSX: TRE, recent price $17.54). But the easiest strategy is not always the best. Because of the volatility in this sector, options on these stocks are relatively expensive. The volatility implied by options on both companies is above 40%, which in terms of cost, sets them in the top quartile of all Canadian equity options.

A better alternative might be covered call writing. With CFP, for example, you could buy the shares at $7.51 and write (i.e. sell) the April 8 calls at 50 cents. The five month return if unchanged is 6.65%. Return if exercised is 14.1% and the downside breakeven is $7.01.

As for TRE, you might want to look at buying the shares at $17.54 and writing the April 18 calls at $1.70. The five month return if unchanged is 9.69%. Return if exercised is 13.6% and the downside breakeven is $15.84.

Finally, since this is the last blog until the new year, I want to wish all of you a very Merry Christmas (I was never that politically correct) and a happy New Year.

Will a better employment picture, a positive, if not spectacular, Black Friday shopping weekend in the US, improve the prospects for consumer-related stocks?

Before getting too excited, let’s not forget that US consumers are still fixing some very fragile balance sheets. Black Friday saw 195 million shoppers visit US stores, up from 165 million the previous year. That’s positive! But, that’s off a base of depressed numbers, as last year consumers frozen by a financial crisis that was just getting into high gear. And note too, that even with signs of stability and a widespread belief that a recovery is underway, consumers still spent approximately US$30 less (about a 10% decline) than last year.

The point here, is that any strategy hinging on the consumer is fraught with risk. Not so much when looking out a year or two, but certainly, when trading over the next three to six months. If investors begin questioning the strength of the recovery then sentiment will shift. Consumers stocks will likely feel the brunt of that sentiment shift.

At this point however, sentiment is clearly behind the consumer. Canadian S&P/TSX Consumer Staples Index soared in November, as did consumer discretionary stocks that were recovering from their late-October dip. Leading a number of analysts who believe the consumer is coming out of hibernation, to post buy recommendations on stocks in these sectors.

Fortunately for option traders, they can ride this consumer backed sentiment with limited risk. Buying January or February calls for example, on stocks like RONA Inc. (TSX: RON, recent price $15.26) or consumer staple stocks like Shoppers Drug Mart Ltd. (TSX: SC, recent price $43.15).

Note though, that options on these stocks have limited liquidity. RON options rarely trade which means you will most likely be paying the offered price when buying and settling for the bid price when selling. You might even think about this position as one you hold to maturity.

On the other hand, RON options – assuming you can buy 10 contracts on the offer – seem to be reasonably priced. Which is to say, the volatility being implied by the options price is less than the historic volatility the stock has recently displayed. For example, with RON trading at $15.26, the RON February 15 calls are offered at 90 cents (implied volatility 25.8% versus historic volatility of 27%)

Trading volumes on SC options are better, and a little more expensive relative to historic volatility. The SC January 44 calls at 45 cents (implied volatility 13.4% versus 11% historic volatility) seem reasonable.

Recognize that these are short-term trades that attempt to take advantage of the current sentiment around consumer related stocks. If sentiment shifts, you have at least limited your risk.

The Montréal Exchange will be hosting its first 2010 Options Education Day in Toronto on
March 13, 2010.

The event will be held at the Metro Toronto Convention Centre (North Building). The program has yet to be finalized.

More details to come!

Is there a point where option premiums are too high? It’s a rhetorical question.

How about this? If premiums seem too high, does that make you a buyer or seller?

That question is not rhetorical. And like most things in the options market, the answer may be counter intuitive.
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