Volatility on sale?

Seems that oil knows no bounds. It continues to set new highs, as do oil stocks like Suncor (symbol SU) and Canadian Natural Resources (symbol CNQ). Same with the broader Canadian market, fueled by a speculative frenzy around energy, commodities and to a lesser extent, gold. All, with no end in sight!

Certainly the US consumer has adjusted well to the current spike in oil prices. Maybe too well! Perhaps it is because of new found wealth resulting from government handouts. Those tax refunds that President Bush promised at the end of last year, should now be in the hands of US consumers.

Of course, handouts provide short term relief. The risk is that the band aid may be masking the real impact higher gas prices.

On the positive side, quarterly earnings have been close to the mark. Like Goldilocks’ porridge, not to hot, not too cold. Earnings drive stock prices, which partially explains the upward bias in the North American stock market. Give or take those 200 point down days when something unexpected happens.

But there too, questions remain. The better than expected results from US companies with a global reach (i.e. IBM, Google, etc.) has more to do with favorable exchange rates, than any real underlying sales trend. Hardly what a securities analyst wants to see.

It’s bad enough trying to forecast earnings at the best of times. Try doing it on the back of a volatile exchange rate. Make no mistake, if the US dollar stabilizes, those numbers will shift quickly.

And what about those short term event driven sell-offs? Normally, investors can dismiss such singular events. Focus instead, on the longer term trend. Unfortunately, that only holds, if the trend is being supported by real fundamentals. And there lies the rub!

The upward bias in the US market, and more so in the Canadian market, looks to be more hype than substance. Oh you can argue that the market is simply forecasting the end of a recession and the return of a robust consumer six months from now. Certainly that’s what the headlines are telling us.

But to accept that, you have to believe that oil prices will not alter consumer spending patterns in the short term. And longer term, not impact inflation in a meaningful way. That’s a two edged sword with a sharp end.

There is a bright side to this. If we are truly in a sentiment driven market, it opens the door to some interesting option trades. Particularly straddles or strangles.

A straddle occurs when you buy a call and a put on the same underlying stock at the same strike price. A strangle is the same thing, but with different strike prices. In both cases, these are volatility trades. They are not directional trades.

Volatility trades pay off if the underlying markets are more volatile than option traders are predicting. Currently, the MX Implied Volatility Index (symbol MVX) which was recently in the 20s, is at 15.88. Simply stated, that means lower option premiums. That’s a positive if we are in a sentiment driven market. Sentiment drives volatility, and with the straddle / strangle, we are buying volatility on sale.

As an example, the iShares CDN S&P/TSX 60 Fund (symbol XIU, recent price $87.36) May 87 straddle could be bought for $2.00 per share. If XIU moves above $89 or below $85 before the close of trading next week, you have a profitable position.

It can also be profitable if the market drops sharply causing volatility to spike. Something that can happen quickly in a sentiment driven environment.