Earnings season is about to get into high gear for Canadian investors. The most interesting group, and probably the most difficult to measure, is the Canadian banks.

What we know, is that this sector has been hit hard. Much harder than I would have expected.

The latest damage is based on potential US write downs of bad credit. The market has been particularly brutal to CIBC (CM) and Bank of Montreal (BMO). Because the market believes that the write downs across the board could be as high as $2 billion.

Here’s a flash… that number could be right, could be too high or could be too low. The point is, no one knows. Even the management of Canadian banks can only offer an estimate. Because in the end, write downs are a judgment call. You estimate what percentage of the outstanding exposure is most likely to default. And then, you ask what percentage of that number can be recovered in foreclosures.

Not surprisingly, volatility among the banks stocks has been on the rise. Options on CIBC are trading with implied volatilities in the high 30s, at a time when the 30 day historical volatility is 23%. Same with Bank of Montreal, implieds in the mid to high 30s, with 30 day historical volatility at 23%.

Royal Bank is in the middle of the pack, also displaying a 23% historical volatility compared with implieds in the high 20s to low 30s.

At the low end of the historical volatility range is Toronto Dominion (symbol TD, 19% historical, implieds in the high 20s) and Scotiabank (symbol BNS, historical 18%, implieds in the mid to low 20s). BNS has less volatility because it should have the least exposure to the US credit markets. Mainly because this franchise has been focusing on South America.

The option market is telling us that most likely, CM and BMO will surprise. Presumably, since the market seems to be betting on a worst case scenario, any surprise would likely be on the positive side. As in less exposure than the market was anticipating.

As for BNS, the betting is that the numbers will be quite good. In fact analysts were expecting good numbers from all the banks had it not been for the write downs. Since BNS is not likely to have serious issues, it is the most likely candidate for a rebound.

If you think the earnings will be better than expected numbers, you could take positions in CM, BMO or BNS. I would stay away from TD and RY, simply because it is just too hard to read whether either will have serious exposure.

If I were playing BNS, I would buy December calls, because the options are relatively inexpensive. In the case of CM or BMO, I would look to option writing strategies. For bullish traders, buy the underlying shares and write December or January covered calls, or naked puts.