The S&P/TSX Composite is now down 40% from its high. Same with the Dow Jones Industrial Average and the S&P 500 Composite Index. Major retreats on the back of last week’s panic selling, marks what historically has been defined as capitulation. As in the point of maximum pessimism when even the hardiest investors sell and head for the safe harbor of capital preservation. The problem is that none of the so-called metrics used to establish maximum pessimism and capitulation have held.

From a technical perspective, North American financial markets have sliced through every resistance point like a hot knife through butter. The next major support, if that has any value, can be found at the lows of the 2000-2003 bear market. Specifically, 7500 on the Dow Jones Industrial Average (Friday’s close 8,451.19, Friday’s low 7,882.51) and 790 on the S&P 500 composite index (Friday’s close 899.22, Friday’s low 839.80). One consolation is that both of these indexes bounced from their lows on Friday with such veracity, that investors witnessed the biggest intraday point swing in history. Again, historically, such an event would have market a major turning point.

Fundamentals have done nothing to provide comfort. Dividend yields have expanded, and price earnings multiples have contracted to points, that historically, have been great entry points, even if we are in a protracted recession. And yet, the bulls continue to be stampeded by the bears.

The MX Volatility Index crossed 90 on Friday and closed at 71. This index measures the volatility being implied by options on the iShares S&P TSX 60 (TSX: XIU). These are record values which by any definition, should imply capitulation.

Interestingly the experts seem to be all singing from the same song sheet, where hardly anyone is willing to say we have reached the point of maximum pessimism. Which by itself, may be the most compelling argument to buy. Given that the financial markets rarely do what everyone expects them to.

As for what the experts think they know, when pressed, most grudgingly suggest that we could see another 10% to 20% to the downside before prices stabilize. Their advice is to generally stay in cash on the sidelines. But that advice, pre-supposes that anyone would be willing to buy after the markets slip another 20%. Which goes to something else we know; few experts – including Warren Buffett - have ever been able to predict a bottom. Fewer still have ever bought at a bottom.

What we know is that the equity market is reeling from a crisis of confidence in the credit markets. Re-establishing that confidence began in earnest last Thursday, when Lehman’s credit default swap book was auctioned. The bad news is that Lehman’s book sold for 9 cents on the dollar. The good news is that Lehman’s book sold for 9 cents on the dollar. Good in the sense that, however painful, a market exists.

We also know from the press release on Friday, that world central banks will co-ordinate efforts to do whatever is necessary to bring stability back to the financial markets. Perhaps now, more than ever, we should follow that sage investment adage; “Don’t fight the Fed.”

Speaking of the Fed and its partner the US Treasury, we also know that some of that US $700 billion bailout package will be used to take equity stakes in US financial institutions. Generally those stakes will be purchased through convertible preferred shares and warrants. What’s important about this, at least from an investment perspective, is that the Treasury will be able to provide moral suasion from the front lines. With government involvement at the shareholder level, banks will have to lend to other banks, or face the wrath of a major shareholder.

We also know, since picking a bottom is out of the question, that the best approach would be to dollar cost average your way into this market. That being a regularly scheduled equal dollar contribution that takes advantage of volatility. Buying more shares at lower prices and fewer shares at higher prices.

Options market bottom fishing

With that in mind, we have a unique opportunity for option traders who are willing to get off the sidelines with a strategy that takes advantage of 1) dollar cost averaging, 2) the record high VIX and 3) buys into the market on the basis of where experts think a bottom may exist (i.e. 10% to 20% below current values).

Let’s look at Suncor (TSX: SU, Friday’s close $26.09) as a case in point. Any option strategy begins with an assessment of the underlying company. As in weighing its chance of survival. There are no guarantees, but assuming the world will need energy at some price, Suncor likely survives. If we accept that, then based on expert opinion, the downside risk is 10% to 20% below current prices, which for SU would put the downside risk somewhere north of $20 per share.

Further, assuming that we will not be able to pick an absolute bottom, and that dollar cost averaging is the best way to enter the game, then we should buy a little now and a little later. Effectively averaging our net price to a point that is at least 20% below the current market value.

For the final piece of this puzzle, we want to take advantage of the record high option premiums. For the record, the longer term options on the SU are trading in excess of 75% implied volatility.

Taking this exercise full circle we come to the covered strangle, a strategy that involves three steps. To begin, let’s assume you would be willing to buy 1,000 shares of SU. The covered strangle begins with a purchase of 500 shares at the current market price of $26.09.

The second step involves the sale of five January (2010) 28 calls (these are technically considered LEAPs) at $10.25 per share. With the sale of these calls, you have agreed to sell your initial 500 share position at $28 per share anytime up to and including January 16th, 2010, the expiration date.

The third step is the sale of five SU January (2010) 24 puts at $6.80 per share. With the put sale, you are committing to buy 500 additional shares of SU at $24 per share until January 16th, 2010, the expiration date.

Conservative investors may want to set aside additional capital in a GIC that matures in January 2010. That’s to provide for the possibility of having to buy 500 additional shares should the puts be assigned. Think of the puts as the option markets version of dollar cost averaging.

Potential and risk
Having laid out the strategy, what does it offer in terms of a best and worst case scenario. To establish that, we begin by calculating the initial out of pocket per share cost. The initial 500 shares of Suncor will cost $26.09 per share. However, you immediately receive $17.05 per share from the sale of the options ($6.80 from the calls + $10.25 from the puts = $17.05), which means your initial capital outlay is $9.04 per share.

The best case scenario would see the stock above $28 per share in January 2010. In that scenario, the call will be assigned, and the put will expire worthless. You will deliver your 500 shares to the call buyer and the trade ends. The return on your initial outlay is 212.5% ($28 sale price divided by $9.04 initial outlay less 1= 212.5%).

The stock could also fall by January 2010. If the stock falls below $24 per share, the puts will be assigned, and you will be required to buy an additional 500 shares at $24 per share. In this scenario, you would end up with 1,000 shares of SU at an average per share cost of $16.52 ($9.04 per share initial outlay + $24 for the second block = $33.04 divided by 2 = $16.52). This is considered the downside breakeven price.

In the worst case scenario, we have taken advantage of dollar cost averaging, and end up with stock at an average price that is 36.7% below the current market price. Thus taking into consideration expert opinion that says we could see 10% to 20% further downside.

The world’s most successful investors make decisions that defy fear and greed. The only way to do that, is to focus on what we know, what we believe and what the market is giving us. With that in mind, click here for a table looking at a number of potential stocks where one could apply the same covered strangle strategy.