The financial markets continue to wrestle with abnormal day to day turbulence. Torn between an old saw that says “you should never fight the Fed,” to continuing uncertainty around financial exposure. Most recently, the focus has been on US bond insurers. On a macro basis, it comes down to the US recession; how long and how deep will it be?

Canada will get off easier than the US. Our exposure to natural resources, specifically oil, will dampen volatility. A fact that has not been lost on the options market.

I note, for example, that the CBOE Volatility Index (VIX) recently traded at 28.10. The VIX measures the volatility being implied by the options on the S&P 500 composite index.

The Canadian equivalent is the MX Volatility Index (MVX) which closed Tuesday at 23.35. The MVX measures the volatility being implied by options on the iShares Cdn S&P TSX 60 fund (symbol XIU, recent price $76.41). The MVX reflects the market’s forward looking assessment about Canadian market volatility, which at the moment, is 16% lower than similar expectations in the US.

Personally, I think the market is unlikely to move significantly one way or the other. If you accept the don’t-fight-the-Fed proposition, it should provide some downside support. Current uncertainty should limit the upside.

If the US market remains in a trading range through the first quarter, the Canadian market will as well. Under this scenario, covered call writing continues to be my favorite strategy.

Having said that, given current volatility assumptions, you could also make a case for writing straddles or strangles. Recognizing of course, this is a significantly more speculative trade.

A short uncovered straddle means writing a call and a put on the same underlying security with the same strike price. A strangle means writing an uncovered call and put on the same underlying security but with different strike prices.

A short uncovered straddle or strangle has limited profit and unlimited risk. The maximum profit is the net premium received. The risk is that the underlying security could theoretically rise indefinitely, or again, theoretically, fall to zero.

The advantage of using XIU, is that you are dealing with a broad basket of stocks. Any company specific issue that might affect a particular stock or sector will not likely drive the index up or down at such a rate that you could not take defensive action.

In favor of the uncovered straddle or strangle is the proposition that the market will trade violently on a day to day basis, but ultimately, will settle within a trading range. If that happens, the credit received from the higher than normal option premiums provide a decent return on the capital used to maintain the position.

An example of a strangle would be to write the XIU March 78 calls at $1.70 and the XIU March 74 puts at $1.45. In this example, you would receive two premiums for a net credit of $3.15 per share. If the stock were to close at a price between $74.00 and $78.00 by the March expiration, both options would expire worthless and you would retain the two premiums.

The upside risk is unlimited. Which is to say, if the stock were to advance sharply prior to the March expiration, the call would be assigned, and you would be required to buy the shares in the open market to deliver to the call buyer.

The downside also has significant risk. If the stock were to decline below $74 per share, the put would be assigned and you would be required to buy shares of XIU at the strike price of the put. Of course, there is little risk that a broad-based index will decline to zero, the worst case scenario for the short put.

In this example, the strangle would be profitable (not accounting for transaction costs) if the stock closed at the March expiration, anywhere between $71.85 ($74 strike of the put less $3.15 premium received = $71.85) and $81.15 ($78 strike of the call plus $3.15 premium received = $81.15).

The strategy would also be profitable if investors became more complacent. In other words, if investors felt that volatility was about to decline, that would be reflected in the price of both the call and the put.

For example, if XIU options were reflecting the underlying stocks historical volatility (i.e. 18%) instead of the current implied volatility assumption (i.e. 23.35%), then all other factors being equal, the XIU March 78 calls would be trading at $1.35 per share (rather than the current $1.70) and the XIU March 74 puts would be valued at 0.82 cents per share (rather than the current $1.45).

BCE follow up

In last week’s blog, I talked about BCE Inc. and was asked to weigh in on the likelihood that this takeover would go through.

As a follow up to that blog, I noted an interesting article in the Tuesday edition of The Globe and Mail. The article also weighed the likelihood of the takeover using the cost of insuring BCE bonds as the foundation.

The article noted that the cost of insuring BCE bonds reflected the risk associated with a company that was carrying significant leverage. That cannot be explained by the current BCE debt to equity ratio.

However, if the takeover goes through, the buyers intend to load up the balance sheet with more than $27 billion in debt. That is significant, and explains why the insurers want to charge more.

According to the article, the bond insurers seem to believe that BCE will become leveraged, which would suggest that the takeover is a go. This over the counter institutional bond insurance market has historically, been pretty accurate at predicting such events. For this one, time will tell.

For disclosure purposes, I own BCE Inc in my investment pools and have written the May 40 calls against our BCE position.

One final point to Derek’s comment. I mis-read the option sheet (thought May was March… need new glasses). So, there are options beyond March.

In fact, the option I was suggesting in the blog (it was re-entered but probably after Derek’s comment) was the May (not March) 40 calls. Further to that point, the May 40 calls were the only ones with enough volume to allow one to trade intelligently.