There’s never been a market anywhere, anytime that didn’t revel in the prospect of easy money. The prospects of a second round of easing (dubbed QE II) by the US Federal Reserve has, in one swift swing of the bat, launched equity markets to five month highs.
The trouble with stimulus programs is that expectations are not usually aligned with reality. It is hard to imagine that QE II will be more effective this time than was QE I, 18 months ago. In the end, simply putting money onto the balance sheets of commercial banks does nothing if the banks don’t lend. And it doesn’t matter the reason.
Of course, all this talk is focusing on longer term trends. Something option traders rarely worry about. More important to an option trader is the impact QE II will have over the short term. That period before the broader markets have time to evaluate the effectiveness of the program.
For example, we know that QE II talk has stimulated stock and commodity markets, sunk the US dollar, rekindled protectionist sentiment, and riled up currency markets.
Option traders might want to bet on a continuation of the commodity rally by taking bullish positions in individual commodity-related stocks, gold or copper miners, for example, or agri stocks.
My preference is to look at bull put spreads on some of the Canadian names in the news. The returns are limited, but there is an inherent hedge, should you be holding a hard asset security if the market concludes that QE II is ineffective. Never forget that strategies with a limited time line can get thrown off course with a shift in sentiment.
Should QE II be dubbed ineffective, all securities will be negatively affected. Even hard assets will become susceptible to supply and demand pricing metrics. Think about it… Aside from the liquidity attributes of QE II, is there any justification from the demand side, for oil prices being above US $80 per barrel? Fact is, if liquidity does not find its way into the economy, demand will wane and pricing models will get re-adjusted.
For the short term, you might look at a bull put spread on Teck Resources class B (TSX: TCK.B, recent price $45.01). In this case, write the in-the-money TCK November 47 puts at $3.30 while buying the TCK November 42 puts at $1.10.
The net credit on this trade is $2.20, which is also your maximum potential profit. The maximum profit occurs if TCK continues to rally and closes above $47 at the November expiration.
This position loses if TCK closes below $44.30 at the November expiration. But the risk is limited to the difference in strike prices less the net credit received. In this case, the maximum risk is $2.70 per share.
You might also look at a put spread on Agrium Inc. (TSX: AGU, recent price $82.12), which jumped $5.43 on Friday. Look at writing the AGU November 84 puts at $4.75, and buying the AGU November 74 puts at $1.10 for a net credit of $3.65 per share. The maximum profit occurs if AGU closes above $84 per share at the November expiration.
The position loses money if, at the November expiration, AGU is below $80.35. The maximum risk is limited to the difference in strike prices less the net credit received. In this case, the maximum risk is $6.15 per share.