A recent poll of 26 analysts and fund managers by Thomson Reuters showed a median forecast of 14,000 for the S&P/TSX Composite Index by the end of 2011. Considering that the index closed at 13,243 on Friday, the median prediction implies a 6% increase for 2011.

This is where options can be particularly useful. If you believe in a more aggressive scenario for Canadian stocks you might look at buying long-term calls to leverage your view. However, if you are of the mind that the 6% median return is a more reasonable assumption – having been garnered from a number of high profile analysts – then you might want to look at long-term options as a way to frame expectations.

If nothing else, a return expectation establishes context. And context is the basis on which rational investment decisions are made.

Putting some meat on this skeleton, we know as of Friday’s close, that iShares S&P / TSX 60 Index fund (TSX: XIU) was trading at $19.08 per share. A 6% increase in value would put XIU at $20.22 per share by 2011 year end. As a base case, we have at a minimum, established a set of return expectations.

The next step is to assess the risk metrics that align with the base case. If you are long XIU, your downside risk is perhaps 10,000 on the S&P TSX composite index, or about $17 for XIU (11% below current levels). Using our base case, going long XIU offers six units of potential upside for 11 units of risk. Almost a two for one risk to return metric.

The options market can help you massage those metrics. Using simple strategies like long-term covered call writing. For example, the XIU June (2011) 19 calls are trading at 95 cents per share. If you write those calls, you reduce downside risk to $18.05 per share. Which effectively cuts downside risk in half.

On the other side, your upside is capped at $19.95 per share, reflecting a six month return of 4.55%. A return, by the way, that occurs if XIU remains unchanged or rises.

At this point, your risk return trade-off has been altered to 4.5 units of return against 5 units of risk. Almost a one for one trade-off. Of course, this favourable risk return trade-off hinges on whether the base case is reasonable. Should markets continue to rally in 2011, the long-term covered call write loses much of its appeal.

Supporting the long-term XIU covered call is the fact that the June 2011 calls are trading at 18% implied volatility. Much higher than the 11.47% actual volatility displayed by XIU over the past few weeks. Obviously, the higher implied numbers reflect risks being priced into the market by traders. The market’s assessment may not be correct, but it is certainly unbiased.

A more aggressive scenario than the base case assumes that the Canadian stock market will continue climbing a “wall of worry.” If so, the 6% expectation could well understate the potential, and therefore, buying longer term calls would make more sense. Despite the fact they may be overpriced relative to historic volatility metrics.

Keeping with the more aggressive theme, traders should look at timing their entry and exit points. If the market is setting up for a sharp rally in 2011, much of it will occur before May. The maxim “buy ‘til May then go away” could be exploited with XIU March (2011) 20 calls, currently trading at 25 cents per share. If you believe that the consensus estimates understate the market’s potential, then the XIU March 20 calls could double prior to expiration.