- Posted by Patrick Ceresna on February 4, 2016 filed in MX Indices, Market, Options Market, Trading Strategies
I find a sense of irony that investors need to be losing 20% or more on their equity investments before the economic experts feel they can officially conclude that it is a bear market. It makes it almost meaningless to react to the news as often the worst part of the portfolio damage has already occurred. None the less, we find ourselves in a situation that is a double whammy for Canadian investors, as they are being pummeled by the currency and the stock market simultaneously. This makes the situation here financially far worse than places like Japan where their 2013-14 currency plight was accompanied by an equity rally, lessening the financial impact on the average Japanese investor.
The brutal reality is that over the last 18 months, any Canadian investor invested in Canadian Dollars owning a Canadian equity fund is down over 20% on their investment and down a further 30% in the decline in the purchasing value of the currency. A hard pill to swallow!
Bear Market Options for Clients
The most common response given to clients is the typical cliché of “don’t panic”, focus on the “long-term plan”. While I fully understand that based on portfolio management theory, a diversified portfolio should be able to weather the storm; the increasing problem is that asset classes that in normal conditions behave uncorrelated suddenly correlate when volatility and fear are introduced to the market.
This is where I feel there is value applying a hedging strategy to reduce an investor’s exposure.
Implementing a Collar to Hedge Risk
While this strategy can be implemented on broader ETFs, we will illustrate the strategy on an individual stock. Let’s discuss a scenario where an investor has owned the shares of Alimentation Couche-Tard. The investor purchased 1000 shares of the convenience store operator back in 2014 at $30.00 a share and has been happy about the rise in the stock price to its current $60.24 level. The investor is torn as to how to proceed.
- The investor likes the stock but is concerned that the stock may reverse lower and fall victim to the broader bear market.
- The key consideration is that if they sell the shares, they will incur over $30,000 in capital gains.
The investor decides to implement an options strategy called a “collar” to protect their investment. This involves selling a covered call on the stock above and using the proceeds toward buying a protective put to hedge the downside risk. Here is the scenario:
- Alimentation Couche-Tard (ATD.B) is trading at $60.24 (February 2, 2016)
- The May $66.00 covered call is bidding $1.20
- The May $58.00 put option is asking $2.50
The investor sells 10 of the May $66.00 covered calls (1000 shares) and receives $1,200.00 in premium income. At the same time, the investor buys 10 of the May $58.00 put options (1000 shares) for $2,500.00. This was at a net cost of $1,300.00 ($2,500.00-$1,200.00).
What has the investor created?
The investor has created a scenario where between now and the May 20th expiration, they have the obligation to have to potentially sell the shares at $66.00, or about 10% higher than where it is trading. At the same time, the investor has guaranteed that if the stock was to decline, they are able to sell it at $58.00, no matter how low it goes. During this time, the investor has 4 months to see how the stock behaves before making that critical decision to realize the tax liability of selling. At least in my eyes, this represents a solid alternative to the rushed decision to sell or hold.