Changing focus to use what the market is giving you

Investors in the accumulation phase of their life might want to look at the recent sell-off as an opportunity to change focus. If one can really think of this as an opportunity.

Before considering any change in focus it is important to understand current market conditions. They are as follows; good quality preferred shares are yielding better than 6%. Investment grade corporate bonds are yielding close to 6%. Quality income trusts (i.e. Bell Alliant, symbol BA.UN) and REITs (i.e. RioCan, symbol REI.UN) are yielding better than 7%. Volatility has exploded to levels never before seen, which means that writing longer term options on quality dividend paying common shares like for example, Agrium (TSX: AGU), Suncor (TSX: SU), Toronto Dominion (TSX: TD) and TSX Group (TSX: X), provide annual yields between 12% and 25%.

If we accept that dividends and other cash flow generate approximately 63% of the total return on a stock portfolio over the long term, then yields have never been better. The same can be said with the current volatility levels, that the opportunity for option writing strategies has never been greater.

Writing options against a portfolio during bear markets is an effective and tax-efficient strategy to provide cash flow for income and reinvestment. The question is how long can you continue to generate income before the market turns against you.

A case study can be examined using energy stocks, where it is a question of balancing the fundamentals of the global oil market with the fundamentals of Canadian energy stocks.

Consider the shares of Petro Canada (TSX: PCA) as a case in point. With the collapse in the price of crude oil to below US $70 per barrel last week, PCA has fallen to a low of $22.75, levels not seen since early 2003, in the early stages of the energy bubble. Two questions come to mind; is PCA likely to retest 2003’s levels before momentum shifts to the upside? Or has the price of oil and PCA bottomed?

If the price of crude drops further, the implications for earnings in Canada’s energy sector will be significant. Major oil sands projects, already on hold, will be shelved indefinitely as costs of production soar beyond the price of a refined barrel of crude oil. Similarly, exploration and development will come to a standstill until prices stabilize.

However, this situation isn’t likely to become permanent. Although it may not seem like it now, bad times do come to an end. Let’s not forget that global demand for energy hasn’t disappeared. It has simply gone into retreat, but will re-emerge all the more powerfully when the next growth cycle begins.

So with PCA, a covered call option strategy can frame your expectations. For example, with PCA currently trading at $25.74, the PCA January 27 calls are trading at $3.25. The sale of the January 27 call reduces your cost of buying shares of PCA to $22.51, below the 52-week low, and at the level last saw in 2003.

If the price of oil rises, it is unlikely to surge. Rather it will probably trade in a range between US $80 and US $90 as the market balances supply against recession constraints. Under that scenario, PCA could rise, but is it likely to surge much above $30 per share. It has to be above that, before the sale of the covered call begins to drag the performance of the stock. At least covered option writing provides a tool to enter the equity markets with some downside protection at a cost of losing out on a major move to the upside.

This approach works well for investors still in the accumulation phase of their life. However, income investors need to take a different tact, where I have expanded this article and included a discussion of how an income investor might approach the current market. The in-depth article will be posted at www.m-x.ca/marc_options_articles_en.php in the Montréal Exchange’s site during the week.