For gold aficionados, it has been a rough eighteen months. Even diehard doomsayers who see gold as crisis insurance have been asking; “where’s the glitter”?
From my perspective, I have never been a gold buff and have never believed it was reasonable to view gold as portfolio insurance. So, we are left with short-term trading opportunities among gold mining stocks where traders try to capture emotionally induced rallies interspersed with sharp sell-offs. Fear and greed play such an important role within this sector!
Because gold stocks consistently display above-average intraday volatility, they do make for interesting covered call candidates. A study I did in the 1990s examined the sale of short term at-the-money calls against a number of gold stocks. Over a ten year period, the covered call strategy produced two to four times the return when measured against a buy and hold strategy for the same stocks. Suggesting that writing covered calls on gold stocks was an excellent strategy to consistently produce alpha.
Seems counter-intuitive to gold buffs, who argue that gold has generated substantial returns since the turn of the century, outperforming most other sectors by a sizeable amount. At least that was the case until the past eighteen months.
In reality, most gold stocks – accepting that some stocks within this sector get taken out to the woodshed because of some unique non-systemic risks (i.e. Barrick Gold being a case in point) – tend to trade within a range and the options market does a decent job of predicting what range is reasonable.
Recent momentum has provided some decent rallies within this sector, which on the surface suggests that gold stocks may have seen their bottoms. Non-systemic risks aside!
If that is the case, then it may be a good time to consider a covered call or naked put strategy. Selling covered calls strategy as an income generating strategy within registered plans. Using the sale of naked put options to take possession of specific gold stocks at lower prices, all the while taking advantage of above average option premiums!
With that in mind, you might want to look at Franco Nevada (Listed on the TSX, symbol: $56.59). You could write, say, the April 58 calls at $2.10. The two month return if exercised is 6.015%, while the return if unchanged is 3.71%.
For the naked put strategy, consider writing the Goldcorp (symbol G, $29.77) July 28 puts at $1.60. If the stock stays the same or rises you will retain the premium from the sale of the naked put. That is your maximum potential return. If the stock declines you will purchase the shares at a net cost of $26.40, which is calculated as the strike price less the premium received. With this strategy, you should be comfortable holding the shares at that price.
Fundamental analysis remains the most commonly utilized investment tool available. Through its use, investors seek to filter out the strongest, or best, valued companies in the market. There is no question about the value of utilizing fundamentals, but it does present the investor with an obstacle. There is a distinct disconnect between balance sheet analysis and the high paced action of the live markets.
“Over the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price).” Benjamin Graham
This best describes the dilemma. No matter how good the value and fundamentals are, the market will not reflect the value in the price until all investors recognize the value (the herd is the voting machine). While there are many people beating the fundamentals drum, they rarely emphasize the psychological fortitude that investors must endure to see through a value investment or fundamental outlook.
The psychology in investing is a powerful force. More importantly, many retail investors tend to invest money that they cannot or do not wish to risk. In many cases, even if fundamentals would prevail over a longer time horizon, many investors that cannot stomach watching their investments decline succumb to selling to stop the pain.
There are two alternative solutions:
1. Develop the psychological fortitude needed to be a long term value style investor.
2. Identify the stocks that you fundamentally want to own and utilize technical analysis in an attempt to identify when a new uptrend could potentially be underway to attempt to diminish the risk being caught on the wrong side of a trend.
We are big advocates of applying technical analysis to fundamental and value based stories in attempts to identify key turning points in trend. The shortcoming of this approach is that the technicals are attempting to time the ambiguous “voting machine” part of the market. This is where options as an investment tool can be utilized.
Options represent a defined certainty, one that the stock market alone cannot give. The most basic example is the protective put strategy. If the investor has both fundamental and technical reason to buy, the investor could simply buy a short-term put protection to fix a guaranteed exit price (if the technical trend fails). The put represents an insurance policy, and more importantly, a psychological floor for risk. To learn more about using puts as protection, investors can watch many great free educational videos on the www.m-x.tv site.
Those of you that are interested in learning more on this topic, I am going to be in Vancouver April 5th to speak at the Options Education Day at the Fairmont Pacific Rim Hotel. I will be presenting a more advanced look at Fundamental and Technical Analysis for Options Trading. Other great speakers like Jason Ayres, Peter Lusk from the OIC and Richard Croft will be there. I am particularly interested to hear Richard discuss the “The Unintended Consequences of Tapering”. Click this link to learn more.
It’s not often you see a company rally despite declining earnings, especially a company that is in the process of overhauling its business model! Nonetheless, that that is exactly what is happening with Blackberry under the guidance of recently appointed CEO John Chen.
Blackberry continues to fall short on earnings no matter how much management tries to manage expectations, and that is likely to continue for at least the next few quarters. Fortunately for Mr. Chen that does not seem to be impacting its’ share price as investors are no longer judging the company on its hardware business. The current focus is on Blackberry’s BBM mobile messaging software.
The company is trying to rebrand itself as a developer of messaging apps for the Android and iPhone markets. Its’ latest and most intriguing apps are the BBM Voice, BBM Channels and BBM voice notes.
The objective is to engage users to share content via BBM as a VoIP (voice over internet protocol) service. If there is a successful uptake by users, then Blackberry can turn its attention to monetizing the service. At this stage, Mr. Chen is getting a pass as he tries to guide a much leaner company through uncharted territory.
The company’s shift has attracted the attention of some large players, most notably activist investor Dan Loeb, who manages the Third Point LLC hedge fund. Like the rest of the market, he is giving the company some wiggle room but eventually will probably want management to spin off BBM as a separate company.
Complicating matters was the recent resignation of Andrew Bocking, who was the executive in charge of BlackBerry’s BBM. That may have been late stage housekeeping, as Mr. Bocking was a key player under the Thorsten Heins administration. Like most new leaders, Mr. Chen will want to put into key positions his own team, but it does raise the level of uncertainty which may well shorten Blackberry’s honeymoon period.
In my mind, this is a last gasp from a great Canadian company. I hope it works, but a lot of things will have to fall into place before shareholders will see any real profits from this division. At some point, BBM will have to produce real earnings or the momentum that is currently driving up the shares will be lost.
If you want to bet on BBM you can buy the stock, but given the real possibility that the company will not produce much in the way of earnings for the next few quarters, you would be buying on the basis that the market will continue to cut the company some slack.
As such, you might think about writing covered calls as the premium on Blackberry options are in the top quartile of all Canadian options. At least you can generate some cash flow while you wait for the BBM saga to unfold.
Many investors seek to enhance cash flow in their portfolios. For the option educated, this can involve the implementation of the Covered Call strategy or selling Naked Calls or Naked Puts. The objective is to collect a credit through the sale of an option contract with the expectation that it will expire worthless. This can occur if the underlying stays the same or moves in a direction that places the written contract Out-Of-The-Money.
A Quick Review
Call Writer - Paid a premium/collects a credit and is obligated to deliver shares at the written strike
Put Writer - Paid a premium/collects a credit and is obligated to buy shares at the written strike
For the Covered Call writer, the obligation to deliver the shares at the written strike is “covered” by the ownership of the underlying shares. The investor incurs a loss as the shares drop in value below the purchase price, less the credit.
For the Naked option writer, the risk is also unidentifiable. As a result, the broker will require the Investor to have sufficient enough capital in their account to cover the obligation. For the record, I am by no means suggesting that these approaches don’t have a place in an options oriented portfolio. In fact, I believe that the Covered Call strategy is a powerful approach to enhancing yield in a portfolio. I also believe that writing puts on shares that you want to own, at levels that you want to own them has its place as well.
The common consideration for the Covered Call, Naked Call and Naked Put is that in all three scenarios, the investor is required to have sufficient enough capital or margin available to maintain the position. Further to that, the credit received for the sale of the option is limited, while the risk on the position is undefined.
To limit the amount of capital required to implement an option writing strategy we can create a Credit Spread. Credit Spreads involve the sale of an option at a strike that is close to the current share price of the underlying and the simultaneous purchase of an option at a strike further out.
Sell the expensive option = collect a credit
Buy the further out “cheaper” option = incur a debit
Net result = Credit
Maximum risk = Difference between the strike prices minus the net credit
Maximum profit = Net credit
The typical approach to this strategy is to sell options that are Out-Of The-Money. The expectation is that as long as the option is written at a level where the stock is not likely to trade with in the time frame, the contracts will expire worthless and the net credit will be realized at expiration.
This strategy can be implemented using calls and puts, however for the sake of this post, we will take a look at a Bull Put Credit Spread.
Out-of the-Money Put Credit Spread - Agrium (TSX:AGU)
Since option prices are based on probabilities, the further Out-Of The-Money the written strike is, the higher the probability that it will expire worthless. The challenge is that the credit received for the spread is significantly less than the risk. This means that you can be right several times over, but the one time that you are wrong and the stock moves greater than expected, the profits from many successful spreads can be compromised.
Take for example the following Put Credit Spread on Agrium (TSX:AGU) with shares at $96.70
SELL April, 92 strike put = $1.60 ($160.00)
BUY April, 90 strike put = $1.35 ($135.00)
Net Credit = $0.25 ($25.00)
(92-90) -$0.25 = 1.75 ($175.00)
Break even on expiration
92-$0.25 = $91.75
To summarize, this trade has a profit potential of $25.00/contract and a risk of $175.00/contract. This represents a 14% return on risk.
Confident in the Direction?
If you were confident that Agrium (TSX:AGU) is going to trend higher over the next month and a half, you could implement an At-The-Money Bull Put Credit Spread for a more attractive risk/reward opportunity.
SELL April, 96 strike put = $3.15 ($315.00)
BUY April, 94 strike put = $2.55 ($255.00)
Net Credit = $0.60 ($60.00)
(96-94) -$0.60 =1.40 ($140.00)
Break even on expiration
96-$0.60 = $95.40
In this example, the trade has a profit potential of $60.00/contract and a risk of $140.00/contract. This represents a potential 42% return on risk.
In the event that the stock stays the same or goes higher, both Bull Put Credit Spreads would expire profitably as the options expire Out-Of-The-Money and the full credit is realized. The further Out-Of-The-Money spread has a higher probability of expiring worthless, however a greater risk is undertaken for that benefit. If the investor is confident enough to take a more decisive stance on the direction of the stock, a greater credit may be obtained with a reduced risk while still taking advantage of the passage of time.
By considering a Credit Spread the the investor is able to generate cash flow by taking advantage of the passage of time. This strategy also reduces the amount of capital required to participate as the margin requirement is typically calculated as the spread minus the credit. By choosing a spread closer to the current value of the underlying stock, a greater credit is received which reduces the the risk. This subsequently reduces the margin requirement further.
It is important to note that the Credit Spread strategy is not permissible in registered accounts.
Something I have discussed at a number of the Montreal Exchange Option Education Days is the theory that markets are efficient, which is to say the stock market is a pricing mechanism where investors come together to evaluate potential return. You buy shares when you believe them to be undervalued and sell them because you think that they are overvalued.
The concept of efficiency rests with the belief that a large collection of buyers and sellers are making decisions on the basis of known, available information will establish a fair market value. That does not mean the end value is correct, only that it is based on rational expectations across a large contingent of investors using real money to establish positions.
The options market works much the same way, except that it evaluates risk rather than return. You write options if you believe that the volatility being implied is too high and you buy options when implied volatility is understating future risk.
A third component of this discussion is an understanding of the term “alpha” which is a concept that quantifies return relative to risk. Theoretically, every point on the risk scale has an attendant rate of return… i.e. higher risk begets higher return. When the return is greater than what is expected for a given level of risk, you have generated alpha or stated another way you have delivered superior risk adjusted returns.
Alpha is a core tenet in the financial industry. Institutional money managers are constantly being evaluated on their ability to produce excess risk adjusted returns; more so in the hedge fund industry where long short strategies incorporating leverage attempt to produce high real returns at coincidently high levels of risk. When it works, the numbers are compelling; when it doesn’t, the fallout is severe.
Unfortunately, risk adjusted return is rarely discussed among individual investors because most have no grasp about the mathematics of risk. Individual investing is more art than science, where decisions are usually the result of gut feelings rather than mathematical precepts.
The trick is to utilize strategies that can be adapted to efficient markets without having to earn a degree in calculus. Hence my preference for a systematic strategy of writing calls against broad based indices. In theory, if one links an unlevered index, that efficiency prices potential return to an option that efficiently prices risk metrics you should generate alpha. A position that has been borne out by the long-term performance of various covered call writing indices.
Writing covered calls against broad based indices, like the iShares S&P TSX 60 index fund (TMX: XIU) or the S&P 500 Depositary Receipts (NYSE, SPY), has generated superior risk adjusted returns than one would get by simply holding the underlying index. Evidence of this can be found in the risk adjusted returns from inception for the Mx Covered Call Writers Index when compared to a buy and hold position on XIU.
For the uninitiated, covered call writing involves the simultaneous purchase of the underlying index ETFs and writing short to medium term at-the-money calls. For example, a covered call would involve the purchase of XIU at $19.91 per share (Friday’s closing price) with the simultaneous sale of ,say, the XIU March 20 call at 25 cents.
By selling the March 20 call you have agreed to sell the XIU shares at $20 anytime between now and the third Friday in March, which is the date the option expires. If the stock is sold at $20 per share, your net return is 1.7%. If the stock remains the same, you keep the 25 cent premium and your net return would be 1.25%; the 25 cents provides some downside protection to $19.67 per share.
So in three out of four scenarios you are ahead of the game writing the covered call. If the stock rises slightly, stays the same or falls you are better off having written the covered call than simply holding the underlying ETF. Only if XIU rises dramatically do you underperform the covered call strategy. Indeed, that is the underlying strategy that is measured by the Mx Covered call writers index.
Still, covered writing indices which measure the performance of selling at-the-money calls against broad based indices, do not substantiate efficient market theory. I say that because writing covered calls against individual stocks has produced no evidence supporting the efficiency of markets. In fact, writing covered calls against individual stocks does just the opposite.
That seeming disconnect is grounded in logic. Whereas the options market is pretty good at evaluating market risk it has never been able to efficiently quantify company specific risk factors. These so-called systemic risks typically drive individual stock prices but are theoretically diversified away within a broadly based index.
So much for long term history! More recently, broadly based equity indices representing the market have themselves been difficult to evaluate. Financial markets have succumbed to crowd psychology as investors try to evaluate macro events at a time when central bank liquidity injections have blurred fundamental economic tenets.
As one might expect, we are witnessing this play out in the performance of covered call indices. Over the past ten years, for example, the Mx Covered call writers index has returned 4.31% compounded annually versus a compound annual return of 5.52% for the XIU buy and hold strategy. Still, when you divide excess return less the risk free rate by the standard deviation of the respective strategies, the risk adjusted results are very similar.
More striking is the pockets of disparity among the two strategies. Since the MCWX index holds XIU as the underlying equity, you would expect it to correlate closely with the returns from a buy and hold strategy where one holds XIU and does not write covered calls.
But in the last three years we have witnessed some unusually large gaps between the two strategies. In 2011, for example, the MCWX Index lost 0.42% compared to a loss of -11.51% in the XIU buy and hold strategy (note we are not including dividends in these performance calculations). Same with 2013, where the MCWX generated about a third of the return that buy and hold produced, which in percentage terms was the worst year of underperformance since inception.
I suspect these gaps are fallout from quantitative easing that has distorted the normal metrics that drive economies and which are ultimately reflected in broad based equity indices. In short, these outside influences are difficult for the option market to quantify.
If these assumptions are correct, then 2014 may be a transitional year. As central banks gradually withdraw liquidity, financial markets will likely revert to normal pricing metrics which can be more efficiently valued by the options market. In essence creating a scenario where the index based covered call strategy once again leads the way in the generation of alpha.
It is hard to deny that Canadian investors feel trampled and broken by the precipitous decline in the gold mining sector. Is it all over? Will gold stocks never go up again? Are all gold stocks destined to be bankrupt as gold will never again be used as a store of value? While anything can happen, it is far more likely that this great bear market in gold stocks will eventually bottom, and that presents a legitimate buying opportunity. It is sometimes helpful to look at the history of past gold bear markets to put this current one into perspective.
Just because gold stocks have declined so severely doesn’t mean that they are necessarily cheap, nor does it imply that they are guaranteed to go higher. In fact, there’s almost no certainty that the gold stocks can’t decline further. Does that mean that investors should not act on the opportunity in light of the risk?
This is where I find options to be strategically useful.
For this example, we will use Barrick Gold.
Here are the facts:
- Barrick (TSX:ABX) is trading at $21.45 (January 31, 2014)
- Barrick has a 52 week low at $14.22
- Barrick has a 52 week high of $33.49
- Barrick’s 2011 highs were at $54.32
For this example, our investor buys 1000 shares of Barrick for $21,450 on the belief that over the next 6 months gold will continue to recover toward its 52 week highs at $33.49.
So let us assess the risk. If proven wrong in having bought the shares, can our investor refute the risk exists that Barrick could return to its 52 week lows?
1000 shares at $21.45
Profit potential to 52 week highs at $33.49
$12.04 or $12,040 profit potential
Barrick remains unchanged
Risk of declining back to 52 week lows at $14.22
-$7.23 or ($7,230) risk to previous lows
Many stock investors may find that proposition acceptable, but let’s take an opportunity to compare the risk/reward proposition if the investor used a 6 month call option as an alternative.
The investor buys 10 contracts of the July $22.00 calls for $1.86. This gives the investor the right to buy 1000 shares at the $22.00 strike over the next 6 months at an average cost of $23.86 ($22.00+$1.86)
10 July $22.00 calls at $1.86
Profit potential to 52 week highs at $33.49
$9.63 or $9,630 profit potential
Barrick remains unchanged
-$1.86 or ($1,860) loss
Risk of declining back to 52 week lows at $14.22
-$1.86 or ($1,860) loss
The stock investor is risking $7,230 in order to make $12,040 in profit potential (1 : 1.67 risk : reward).
The options investor is risking $1,860 in order to make $9,630 in profit potential (1 : 5.18 risk : reward).
The key observations are that the options investor could experience a full $1,860 loss if the stock remains unchanged. At the same time, beyond the premium paid, the options investor is not exposed to any of the downside risk of the stock and therefore, if the shares drop to their 52 week lows, the investor can try again to buy the shares at the lows. Alternatively, the traditional investor has only the choice to dollar cost average a stock that is down over 30% from the entry price.
As a trader, if you cannot increase your probabilities of winning, you can at least ensure the opportunities represent an asymmetrical risk/reward proposition. In this case, if the trader’s outlook is proven to be correct, the call option gives the opportunity to make 5 times the amount risked.
Our readers would certainly ask the question, what is the downside to this approach? The key considerations have to be associated with timing. The share investor is not contained to any predefined time frame, while the option investor has to make a key decision to exercise or sell before the July expiration. Therefore, the option will always be best suited for objective based traders with a defined plan of action.
John Aziz (www.msn.com) penned an interesting article recently where he asked the question “are financial crisis really preventable?” And the answer, not surprisingly, is that they are not because “the world is just too unpredictable.”
In order to prevent something, you have to first be able to articulate a cause and effect. The real estate bubble that caused the 2006 financial crisis was years in the making. And while some – very few in retrospect – articulated concerns about an impending sell-off, the price escalation lasted much longer than anyone could have predicted.
History is filled with similar examples; the internet tsunami in the 1990s, Japan in the 1980s, tulip bulbs in the 1600s and virtually any boom and bust scenario throughout history. Fear leads to euphoria ending in calamity.
And looking back, was there a smoking gun that might have predicted or better, prevented a boom leading to a bust? Could Congress have enacted legislation that tightened controls on mortgage lending in 2005? Did the Japanese government raise any red flags about the asset bubble in the 1980s? Unfortunately, preventative measures are brought into play only after the fact. And that cause and effect leads to another boom bust cycle.
Think about it in todays’ terms. Regulators try to reign in risk with tighter controls on derivative transactions and credit availability, which creates a vicious circle of unintended consequences. Central banks provide excess liquidity in an attempt to encourage lending that cannot occur because of a tighter regulatory framework. Fact is money knows no borders and attempts to rein in leverage within the real estate sector create other bubbles, like the meteoric rise in equity values despite questionable economic fundamentals.
Despite all academic evidence in support of efficient markets, the fact is asset values are difficult, if not impossible, to quantify. They are rarely based on hard data, but rather what investors believe someone may be willing to pay in the future. Throw in uncontrollable and unpredictable macro incidents like war, terrorist acts, weather related events, new technologies and scientific breakthroughs that can alter investors’ perceptions. Any attempt to predict a bubble, let alone prevent a collapse, would mean preventing all of these kinds of shocks.
Those predicting bubbles rely more on art than science. Aziz noted in his article that even when analysts accurately predict bubbles, as Peter Schiff and Marc Faber did with the housing crisis, more often than not those same pros whiff in the aftermath. Schiff and Faber have both warned about a bubble in the stock market, treasury bonds, and the US dollar. So far they have been wrong.
If there is no way to accurately predict a bubble, how can one be expected to prevent one from bursting? Consider the current environment, where the US Federal Reserve has pumped massive liquidity into the US economy. Is that good or bad?
Without signs of inflation, one could argue that the Fed can print money as long as it wants. One could also argue that the Fed is buying treasury bonds, which represent debt that must eventually be repaid by the US taxpayer. Both points of view may be correct depending on the timeline being applied. They may also be irrelevant!
I see this firsthand when talking with clients. Double digit returns are expected on the back of bloated numbers from equity markets financed by central bank liquidity (note specifically the equity markets in the US and Japan). That’s not normal, nor can it be expected to continue indefinitely.
I also hear talk about alternative investment like mortgage backed securities that provide fixed returns with reasonable risk. But what is reasonable? Returns tied to higher risk leveraged loans backed by the belief that real estate will always rise? Sounds eerily familiar to the pitch used to sell mortgage backed securities in 2005!
But here’s the thing, and there is no way of getting around this, booms and busts are driven by fear and greed. And there is simply no way to prematurely predict shifts in sentiment.
So, if we cannot predict sentiment shifts, is there any way to contain sentiment? The answer is probably not! Investors could establish a personal portfolio benchmark that has historically delivered a satisfactory rate of return. But that only works if the investor is willing to focus on the long-term results rather than short-term aberrations.
For example, some years ago Professor Eric Kirzner and myself created a series of portfolio benchmark indices for the Financial Post. These became known as the FPX indices, of which there were three; Income (i.e. conservative), Balanced and Growth. You can read about how they were constructed at http://www.croftgroup.com/indexes/fpx.htm and you can review periodic returns using a benchmark calculator at http://www.croftgroup.com/indexes/calculator.asp. You can also review the periodic returns for the Mx Covered Call Index and the Mx Straddle Writers Index.
If we examine the results for last year, the FPX Growth Index returned 15.06%, firmly beating the less volatile FPX Income Index that returned 2.57% over the same period. But look at the numbers over the entire time; these indexes have been in existence and it paints a much different picture. In fact, the 18-year return from all three FPX Indices is virtually identical, which tells us that well-diversified portfolios get you where you want but take very different paths to get there.
That’s the rub. Investors want what is here and now without understanding the risks associated with short- term returns. That’s why financial advisors are always trying to dampen expectations in recognition of the fact that no one can accurately time end games.
Blackberry (TSX:BB) has enjoyed a fairly impressive snap back over the last few weeks. Since the beginning of December, shares have climbed from $6.00 to $10.00, or a whopping 66%.
The turnaround can be attributed to a couple of things. John Chen took over as CEO back in December , signing a manufacturing agreement that set the tone for a renewed confidence from investors. This is perceived to be the start of a possible recovery for the Canadian tech giant and warranted an upgrade from RBC.
According to the Financial Post, Although BlackBerry still faces substantial long and short term challenges, RBC Capital Markets financial analyst Mark Sue believes the company’s new management team is moving quickly to “improve liquidity and strengthen the balance sheet.”
That being said, according to Bloomberg, of the 41 analysts that track Blackberry, 27 are neutral, hold or sector perform. Eleven suggest a sell/under perform rating while only 3 have a buy/outperform rating.
I don’t fully believe that the recent share appreciation is due exclusively to the change in management. While this certainly provided a catalyst, I would also suggest that with such a huge percentage of short interest, we have seen and are still seeing a good ol’ short squeeze taking place.
What’s a Short Squeeze?
When a stock begins to show weakness, sophisticated traders and investors will “sell short” the shares. The intention is to borrow the shares from their broker and sell them at the higher price. They then receive the equivalent amount as a dollar credit to their trading account. This creates an obligation to cover the shares or, in other words buy them back and return them to the broker. The object is to buy them back for less then what they were sold for. The trader/investor then only has to use a portion of the credit they received to cover their obligation and return the shares. The result is that they keep the difference and lock in a profit.
Of course the opposite occurs if the shares trade higher then the shorted price. In this case, the short trader/investor must buy to cover at a higher price, giving back the credit plus the difference between the short price and the higher market price.
A short squeeze occurs when there is a large short interest in a stock and the prices start to rally. As the price of the shares rally, the short trader/investor must “buy to cover” their position to take profits or cut losses. It becomes self-perpetuating in that the higher the price goes, the more the “shorts get squeezed” and are forced to buy to cover and with demand increasing from the buying, the price goes higher…and so on. This gives the illusion that buyers are entering into the market because shares are undervalued when really, it is just the result of profit taking and risk management on the part of the short interest.
So what Does This Mean?
Blackberry’s short interest has decreased significantly over the last few weeks. This does not mean that the stock is now guaranteed to trend back to it’s previous historical highs. As I quoted above, many analysts believe that they are not out of the woods yet. However, we may be able to catch the tale end of the short squeeze momentum higher, and renewed interest from investors who have been on the sidelines. In fact, just the other day, a friend of mine who does not trade or invest asked me how to buy options on Blackberry. This indicates to me that the average Joe is now interested in putting a little capital towards the stock and suggests that we may be able to catch a short term push higher on that renewed public interest. After all, to paraphrase Jesse Livermore, there is no better way of advertising if you want to attract buyers then increasing the price of the stock…the public is listening and buying it.
While I don’t believe that the share value will continue to climb higher in a straight line, it is quite possible that we will see $12.00 over the next few months. While we could buy the shares out right, with a short term upside target in mind, I would be more inclined to use a Bull Call Spread
The Bull Call Spread
The Bull Call Spread involves the purchase of Call option and the simultaneous sale of a Call at a higher strike.
The spread trader pays a premium for purchasing the call and a debit takes place in their trade account. At the same time, the call at the higher strike price is sold and a credit is added to the trade account. Since the call at the lower price costs more than the call that was sold further out of the money, a debit is still incurred.
The profit potential is limited to the spread between the long (purchased) Call and the short (written/sold) Call.
So since we are bullish we are using calls. With this strategy we can only benefit in the upside move in the stock by the spread difference. The trade is still a net debit to the trading account.
A Bull Call Spread on Blackberry (TSX:BB)
On Friday, January 12 2014, Blackberry (TSX:BB) was trading at $9.50.
- A March expiration, $10.00 strike call is asking $0.75 or $75.00/contract
- After BUYING 1 contract, the investor would see a $75.00 debit in their account
- A March expiration, $12.00 strike call is bidding $.15 or $15.00/contract
- The investor would SELL this call and a credit of $15.00 would be added to the account
- This would result in a net debit of $60.00
The North American economies got an early Christmas present when, in uncharacteristic fashion, cooperative efforts in Washington took the debt debate off the table and pressured some high profile programmers to fix the healthcare.gov website on time. Newly appointed Federal Reserve (Fed) Chairman Janet Yellen eased into power as departing Chairman Bernanke announced the Fed’s intention to taper its’ bond purchase program. Talk about a Goldilocks scenario!
Effectively these negotiations took government wrangling off the table, which means that investors can now focus on expectations for the real economy. That’s a good thing, and something that Canadian investors have been doing for some time.
What we want to see is more signs of a real sustainable US recovery, which would benefit Canada. From two perspectives; it would help Canadian exporters and drive Canadian equities, which have underperformed the US for the past two years. Time to play catch up!
From my vantage point, I think that current bullish bias will stabilize equity markets through what looks to be a weaker first half. I say that because US consumers’ may be reluctant to spend and corporate America may be averse to hiring until both sides have a clearer understanding of the costs associated with Obamacare.
On the bright side, those costs may come in less than expected. If we draw anything from the Canadian experience, government controls will cap heath care costs which would moderate the double digit increases that currently exist in the US and ease the inflationary pressures resulting from rising interest rates. That could be very positive for stocks in the second half.
Another potential positive is North American energy independence, which is already in place. So far we have only been privy to anecdotal evidence about the long term implications, but clearly it will alter the global political landscape and more importantly provide cost effective secure energy to North American companies, which removes yet another impediment to growth.
Given this backdrop, it is likely that Canadian sectors leveraged to the US recovery will out-perform the broader US market as measured by the S&P 500 index. Front and center in this discussion are Canadian exporters, transportation companies and financial services. Enbridge, Trans Canada Pipelines, Canadian National Railway and Canadian Pacific could see decent results while Canadian banks should lead the way to recovery. Blue chip Canadian names afford a secondary advantage as rich dividend payouts provide investors with a homemade put option that can limit downside risks.
On the other hand, I am not as comfortable longer term with commodity based stocks like Agrium and Potash, energy companies such as Suncor and the gold miners particularly Barrick, Goldcorp and Agnico Eagle. Part of my concern is the lack of inflationary pressures which are key drivers for commodities, energy and most certainly precious metals.
With that in mind, you might look at buying six month or longer calls on Canadian National Railway (TSX: CNR, Friday’s close $60.08) and / or Canadian Pacific (CP, $159.45). For CNR look at the June 60 calls at $2.75 or better. With CP consider the July 160 calls at $10 or better.
We are witnessing a major shift in risk allocation across asset classes. As the bond market prices in tapering, medium and longer term rates are rising. With short term rates at or near zero, and likely to remain there for some time, the yield curve is steepening.
As these price adjustments work their way through the system, we have a scenario where bonds are riskier than equities. Rather than bonds trading at about 70% of the volatility of a broad equity index, there is real risk that fixed income volatility will exceed that of equities for perhaps the first time in history!
Conservative income seeking investors are re-thinking their investment strategy. Shortening the duration of their bond allocation is one approach, although that has a serious impact on income. Another strategy is to move into sub-investment grade bonds where higher yields tend to dampen volatility related to interest rate shifts. But assuming higher default risk is not something most conservative investors are comfortable with.
Covered calls on Canadian equities may provide a third low risk choice, particularly if you focus on blue chip Canadian companies that pay decent dividends. BCE Inc. (TSX: BCE, $45.24) is one that comes to mind. The annual dividend is $2.33 which equates to a 5.15% yield, and the company has been regularly raising the dividend since the Teachers Pension Plan decided to opt out of their purchase offer.
Now take the dividend and add some premium income from the sale of covered calls, say by writing the May 46 calls at $1.00. I am using at-the-money calls because this trade is being examined as an alternative to fixed income securities. The idea is to make the equity look like a bond with a higher yield and a fixed upside at expiry.
The covered call strategy has a long history of reducing volatility usually by as much as 30%. Much like we see with the Mx Covered Call Writers Index (symbol: MCWX), which writes covered calls against the iShares S&P TSX 60 Index fund (symbol: XIU). When you measure volatility in the MCWX, it is about 70% as volatile as a long only position in XIU. That brings the covered call strategy in line with longer term volatility associated with fixed income securities.