Option Matters will be closed until August 16th. We’re going to recharge our batteries for another year.

Enjoy summer!

At the opening of trading on Tuesday, August 3, 2010, MX will begin trading new options on the following four equities:

• Anatolia Minerals Development Limited – ANO
• Corridor Resources Inc. – CDH
• Gabriel Resources Ltd. – GBU
• Premier Gold Mines Limited – PG

On July 28th, the Montréal Exchange will launch a new “Education” section in the main navigation bar of the MX site. One of the key features of this section is to have links to our educational offerings (webinars, videos, blog, guides and strategies, workshops) in one location only. What’s more, we are adding educational content provided by The Options Industry Council under a content licensing agreement with MX.

Additional enhancements include:

• merger of the “About Us” and “Media Room” menus under one “About Us” menu for better content organisation;
• addition of an identifier to indicate a third-level menu;
• new “Affiliated Sites” quick links in the left column of the site.

We encourage you to navigate through the new Education section to learn more about the use of options.

The Canadian stock market has moved back and forth in a fairly narrow range (between $16.50 and $17.50 on the S&P/TSX 60 iShares (symbol XIU, Friday’s close $17.16). That said, there have been periods where the market has moved sharply higher or lower. Which is to say, volatility is high relative to the actual trading range of XIU.

Interestingly, the Canadian market has traded tightly around its 20-day moving average. No momentum. Typically strong upward moves – as we saw in early June – are followed by sharp sell-offs (witness the middle of June to early July).

Of course, markets eventually break out of a range. The question is when. And to this point I see nothing that suggests a serious break out in either direction until perhaps, the beginning of the fourth quarter.

With that in mind, traders might look at selling September straddles. Specifically selling the XIU Sept 17.50 calls at 30 cents and the XIU September 16.50 puts at 30 cents. The net premium received from the sale of the straddle is 60 cents.

This trade will be profitable if XIU is between $15.90 and $18.10 at the September expiration. The maximum profit occurs if the XIU closes anywhere between $16.50 and $17.50 at the September expiration.

At the opening of trading on Monday, July 26, 2010, long-term series will be added to the following option classes:

• Eldorado Gold Corporation - ELD
• Enbridge Inc. - ENB
• Nexen Inc. - NXY
• Osisko Mining Corporation - OSK
• Pacific Rubiales Energy Corp. - PRE
• Shoppers Drug Mart Corporation - SC

Is the Canadian market heading lower?  We are now two weeks off an important test of the January/February lows. If the market is simply retracing from an oversold state, then we should should see the Canadian market struggle at these overhead resistance levels. We will be observing if the 17.40-17.60 levels on the XIU contain all rally attempts.  If it does, then there are a number of bearish scenarios to consider. 

For more information watch our Canadian Market Minute video:
http://www.optionsource.net/mediaplayercanadian.php

My view last week was that the markets could reach their most recent highs (that would be approximately 12,000 on the TSX Composite Index or 10,400 on the Dow Jones Industrial Average). The TSX has yet to reach its mark. But the DJIA did and then pulled back… abruptly!

Earnings were expected to be positive. And many felt that would be enough to entice buyers back into the game. At least for the short term. But so far, earnings have been a mixed picture, and macro events continue to drag investor enthusiasm.

What’s clear is that global economies are not recovering as fast as expected. For that to change, consumer spending will have to step up big time. Especially as governments gradually withdraw stimulus programs.

The problem is that no one sees that happening. Which is why, after just a week of second quarter earnings, analysts are already lowering expectations.

Traders need to be cautious, and if anything, might want to reassert their bearish bias over the near term. Potential option strategies include 1) buying puts or 2) writing bear call spreads.

Buying puts is the first choice if premiums remain relatively low. Before deciding which strategy to use, check the levels on the MX Implied Volatility Index (symbol MVX). The MVX closed on Friday at 16.53. I would consider any level below 20 as a low number in the current market environment.

The S&P/TSX 60 Index Fund (TSX: XIU) closed Friday at $17.03. If you buy the bearish scenario, look at buying the XIU August 17 puts at 43 cents or better. The XIU options are liquid so you should have no difficulty moving in or out of any position.

Bear call spreads make more sense if option premiums make the cost of an outright purchase prohibitive. As mentioned, that would be any value above 20 on the MVX.

A bear call spread, like any spread, typically reduces the impact of volatility. A spread involves the simultaneous purchase and sale of options on the same underlying security. If you overpay for the long option, you are benefiting from the excess premium received on the sale of the short option. Effectively one option premium cancels the other.

Typically, you would sell an at-the-money or in-the-money call and simultaneously purchase of an out-of-the-money call. For example, with XIU, you could write the in-the-money August 16.50 calls at 75 cents and simultaneously purchase the out-of-the-money August 17.50 calls at 20 cents. This bear call spread generates a credit of 55 cents.

This spreads maximum profits occurs if, at the August expiration, XIU is below $16.50. At that point both of the XIU August calls expire worthless and you retain the net credit received.

The risk in this position is limited by the purchase of the August 17.50 call. If XIU were to rally above $17.50 between now and the August expiration, any additional losses on the short August $16.50 call would be offset by gains on the long August $17.50 call.

The maximum risk with the bear call spread is the difference in strike prices less the net credit received (Aug 17.50 call minus August 16.50 call = $1.00 risk less $0.55 net credit received = $0.45 net risk).

MX and the OIC are on the road again with our upcoming Options Education Days in Montréal (September 11th) and in Toronto (September 25th).

For information on the Montréal event, click here.

For information on the Toronto event, click here.

Don’t miss this opportunity to develop winning trading skills!

I received a comment on the Death Cross trade that I talked about last week. I will get to that in a moment.

As for last week’s commentary, the technicians version of the death cross proved to be fallible. At least over the short term!

A couple of points to consider before changing focus. The first reflects my position that up until last week, investors were focusing on macro events. The global economic picture does not look particularly appealing and it was those fundamentals that produced the technicians version of the “death cross.”

What happened last week was a clear shift away from macro events and onto the upcoming earnings season. Things on that front look pretty good, as most traders are looking for upside earnings surprises.

Over the next month or so, the earnings focus may be enough to take the markets to the top of their trading range. I doubt it takes us much beyond that.

Now to the comment. Richard tells us that he sold all of his positions on June 29th, but likes to trade bear markets. He talked about writing naked calls. But his concern was that volatility tends to abate when markets are rising, which reduces the potential income from a naked call.

He wanted to know whether there is an option play that I preferred to use in bear markets. To begin, the naked call is not a strategy I like, because I believe there is too much potential risk. My preference is bear call spreads.

There are two reasons for this: 1) a spread limits my risk and 2) because a spread involves the purchase and sale of options on the same underlying security, it effectively removes volatility from the decision making process.

With volatility eliminated, I can focus on the direction of the underlying security. If I am right in my timing of the entry point, the bear call spread will be profitable. If I am wrong, as seems to be case from last week, I have limited my risk.

A technical indicator known as the “death cross” was breached last week. This occurs when a 50-day moving average drops below a 200-day moving average. Last week, we saw just that on the Dow Jones Industrial Average and the S&P 500 Composite Index.

The Canadian market did not trigger the same signal, but it could this week. The 50-day moving average on the iShares S&P/TSX 60 Index Fund (symbol XIU, recent price $16.45) touched the 200-day moving average at the close of trading last week.

The death cross is viewed as a bearish signal, and has in the past preceded further market slides. In the US, it last occurred in December 2007, after which the S&P 500 dropped 50%. Technicians tell us that the death cross has preceded every bear market since 1972.

Of course, it’s not a guarantee and nothing is failsafe. But it does tend to confirm the fundamental economic indicators, which are flashing warnings of a slowdown in the pace of global economic recovery. And so far, investors have found nowhere to hide. Including gold stocks!

If we accept that the death cross typically precedes a bear market, then we have to ask if the current sell-off is a precursor to a bear market, of simply a correction in a bull market. If the latter, the death cross carries less weight. It might still precede downside action, but the scale of the move may be limited.

Either way, I suspect a move to the downside will occur over the next couple of weeks. For one thing, there does not appear to be any macro event that will stimulate a bullish reaction. And with nothing coming in from the earnings front until after the July expiration, the market will be focused on macro events.

Aggressive traders should look at positions that offer lots of potential with limited risk. Which is to say, at-the-money July puts. One approach is to buy puts on the Canadian dollar hedged iShares S&P 500 Index Fund (symbol XSP, Friday’s close $11.76). The problem with XSP is that the options have limited liquidity. That typically translates into wide bid asked spreads.

On the other hand, XSP is a pure play – albeit hedged back to the Canadian dollar – on the US stock market. If you go this route, look at the XSP July 12 puts and don’t pay more than 50 cents per contract.

A more liquid approach is to buy puts on XIU. Not a pure play, not exactly the same technical signal, but much greater liquidity. Try the XIU July 16.50 puts at 35 cents per share.