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Over the last year we have seen an incredible period of low volatility that is arguably building systematic liquidity risks when we enter a period of normalization.  These risks were highlighted in the Bank of Canada’s November 2017 Financial System Review.  In that review, the BoC discussed the assessment of vulnerabilities and risks, highlighting the driving strategies in the low-volatility market environment.  They propose that there is a chance that the pricing of risk may be in line with fundamentals, but there is equally a chance it is not.  If it is not, it could be leading to investors taking excessive exposure to risky assets by using financial leverage.  They go on to highlight the growing popularity of the short VIX trade “suggesting that investor expectations of a persistent low-volatility environment have become more entrenched.”


Source: Bank of Canada November 2017 FSR

This arguably is growing big enough to impact markets if a catalyst drove volatility back to its historical norms.  Through volatility targeting strategies and direct short volatility products, it is suggested that there is as much as $2 trillion of exposure. In that report, the BoC particularly highlights the risk-parity strategy.  Those not familiar with the vol targeting funds, they often, on a leveraged basis, seek to rebalance the portfolio asset allocation based upon targeting a specific level of risk.  Today’s low volatility environment has essentially allowed this managed money to leverage up.  Arguably the question many quantitative analysts have openly asked – will there be sufficient liquidity in the market when all of these funds are forced to sell to rebalance the risk?  This remains one of the most prominent known threats to the well-established bull market.

At MacroVoices, we had the opportunity to bring Chris Cole from Artemis Capital on the show, discussing these imbalances.  He further expands on his views that this short volatility exposure is not just the explicit short VIX trade, but rather much greater.   While there is that further implicit short volatility trade of near $2 trillion dollars, this is further fueled by company share buybacks which arguably added a further $3.8 trillion dollars of price-insensitive buyers (since 2009) that have been systematically buying the dips a suppressing overall volatility.

So, what is the problem with that?

According to Chris, “part of that is the expectation that markets remain low volatility or low realized volatility. So, there is this implicit short Gamma exposure.”

This implicit short gamma, could arguably could force risk parity and volatility-controlled funds to deleverage in the tune of $500 billion dollars if the markets were to correct 5% lower, accompanied by a 50%+ increase in implied volatility.

Is this guaranteed to happen?  No.  Is it a risk?  Absolutely.   

How does this impact us in Canada?

Canadian stock markets share a strong correlation to global markets and particularly to the U.S. markets.  Systematic risk can spread like contagion leaving Canadian markets indirectly vulnerable.  To demonstrate the correlation, observe the overlay of the American VIX and the Canadian VIXC.

What to do?  I continue to advocate that investors that have profited from the very bullish market advance to consider buying portfolio insurance in the form of protective puts. While the market volatility is off the lows of November/December, the VIXC is still within the 2017 ranges.

To illustrate the ideal of buying protection, we can use the Canadian iShares TSX60 Index ETF (XIU).  The ETF rallied 10% from its September 2017 lows at $22.00 to its late December 2017 highs near $24.50.  With it currently trading at $23.82 (January 30, 2018), an investor would pay a very reasonable $0.17 per share or $17.00 per contract to hedge all downside risk of $2,300.00 of exposure below the $23.00 level out to the March 2018 expiration (IV 13.50%).  Each investor approaches investing differently, but in my mind, I never blink twice to spend some of my profits to hedge risk and create less volatility in the accounts.

The post Risks Stemming from Current Low Volatility Conditions appeared first on Option Matters.

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As the following graph shows, the share price of Premium Brands Holdings Corporation (PBH) has been on a bullish trend, with some more or less large corrections since reaching a plateau in the spring of 2017. Until we see evidence to the contrary, we should assume that this trend will continue for a while.

Daily chart as at January 29, 2018 ($106.50)

A bullish trend like this one does not provide any well-defined target prices for making an optimal selection of call options. Furthermore, since the amplitude is rather limited — the chart clearly shows plateaus lasting several weeks — selling put options appears to be our best strategy, since it will allow us to profit from both rising prices and relative price stability.

Position

  • Write 10 put options, PBH 180420 P 105 at $3.50
    • Credit of $3,500

Profit and Loss Profile

By writing the 10 put options, PBH 180420 P 105 at $3.50, we collect $3,500 ($3.50 x 10 contracts x 100 shares per contract). As the above table shows, this option is currently out-of-the money and has no intrinsic value. As a result, 100% of the premium is time value. So we are taking advantage of the time decay from now until April 20, 2018, if the price of PBH rises, but also if it is relatively unchanged or even if it falls down to the $105 strike (the static profit). We will realize the strategy’s maximum profit if PBH closes at a price higher than or equal to the $105 strike when the options expire on April 20, 2018. This maximum profit represents a 3.4% return over 80 days (a 15.7% annualized return). The $3.50 premium also gives us a cushion against the stock price declining by as much as 4.5%, meaning that it can fall to the breakeven price of $101.50 (the $105 strike less the $3.50 premium) before the position begins to produce losses.

Intervention

There are three ways to manage this position. The first is for an investor who is not afraid to buy the shares if their price falls. In this case, the position is held without any intervention, and if the stock falls below the strike of $105 upon expiration, the shares are assigned and the investor simply buys them back. The second approach is to intervene if the price falls significantly below the breakeven price, by buying the put options written as a way to cut your losses. The third approach involves intervening if the price of the shares rises significantly, by buying back the put options written for 10% to 20% of their initial premium (in this case, for between $0.35 and $0.70). In the last two cases, other put options can be sold if it is still justified.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The post Writing Put Options to Profit from Higher Prices for Shares of Premium Brands Holdings Corporation appeared first on Option Matters.

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As you can see in the following graph, shares in Canopy Growth Corporation (WEED) have shot up in price since bottoming out at $6.58 in June 2017. This represents more than 600% growth to its recent peak at $44. Since then, WEED has slipped, falling to $29.50 before bouncing back and has been fluctuating in a range that could become a buffer zone for a while. If this is true, the situation could represent an opportunity to implement a strategy that takes advantage of the stock’s relative stability and, consequently, of the time decay of the option premium, which is very high right now with an implied volatility of over 80%.

Daily chart of WEED as at January 22, 2018 ($37.38)

Establishing an iron butterfly spread would allow us to profit from these conditions. It would not come as a surprise if the current pause turns out to be only temporary, so we choose an expiration of February 16, 2018.

Position

 

  • Purchase of 10 call options WEED 180216 C 48 @ $0.50
    • Debit of $500
  • Sale of 10 call options WEED 180216 C 38 @ $2.35
    • Credit of $2,350
  • Sale of 10 put options WEED 180216 P 38 @ $3.50
    • Credit of $3,500
  • Purchase of 10 put options  WEED 180216 P 28 at $0.40
    • Debit of $400
      • Total credit of $4,950

Profit and Loss Diagram for the Iron Butterfly Spread

As you can see in the above diagram, we will make a maximum profit of $4,950, derived from the total net credit received, if WEED closes exactly at the strike price of $38 when our options expire on February 16, 2018. This position will be profitable as long as the price of WEED stays within the two breakeven prices of $33.05 and $42.95. The strategy will generate losses on either side of these two breakeven prices, with a maximum loss of $5,050 below the strike of $28 and above the strike of $48. The maximum loss is the difference between the strikes of the call options and the put options less the net premium per share, multiplied by the size of 100 shares per contract and by the position of 10 contracts: ($10 – $4.95) x 100 x 10.

Intervention

In taking this position, we are counting on the stock price being relatively flat for a period of time, but there are no guarantees that this will occur. So as long as WEED stays between the two above-mentioned breakeven prices, we do not need to intervene in any way. However, should the price break through either of these levels in a major way, we would be in a precarious position and exposed to potentially large losses. Such a situation would force us to take defensive measures, closing the position and absorbing the loss.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The post An Iron Butterfly Spread on Shares of Canopy Growth Corporation appeared first on Option Matters.

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The last few years have been a struggle for Goldcorp investors.  The company has been overshadowed by declines in earnings, falling gold production and increased costs.  Many investors have abandoned the stock for other gold miners with more momentum.  Yet there are a number of green shoots that suggest the management is turning things around.  There has been considerable cost cutting to try to stabilize earnings while the outlook for production is increasing toward 3 million ounces by 2020.

There comes a transitory moment in a stock where the disappointments of the present are outweighed by the opportunities of the future. That moment usually comes unnoticed by many as most have left the stock for dead and simply are positioned elsewhere.

Will investors be rewarded for taking a risk here or will the stock still be overshadowed by its disappointing 2017 performance? What are the risks? How does one position themselves into the stock?

Looking at the price action of Goldcorp over the last month, one can see the stock has bullishly broken out of a high-volume consolidation zone between the $15.75-$17.25 zone, hitting a swing high of $19.32 before its current consolidation.  From this price action alone, traders will be looking to see if the pullbacks are being bought on dip.

Short Term Calls as a Stock Entry Strategy

This makes Goldcorp an interesting trade opportunity if one can manage the risk.  So how can we build an options strategy around the stock?  This is where I like to consider short-term call options as a way to enter a new stock position.   Those not familiar with options, the call secures the right to buy a security, at a specific price, over a specific period of time.

Why use the option instead of buying the stock?

Like a mulligan in golf, it offers me an opportunity to lock in a potential purchase price, but… if the market proves that I am too early and the stock declines, I can walk away from the call option for a small loss and have a second try on a new entry from a potentially better level.

Let’s go through an example:

  • TSX:G is trading at $17.80 on January 22, 2018
  • The February 9th, 2018 $17.50 call option (weekly) is $0.65 (18 days till expiration)
  • We buy 1 call option for every 100 shares of stock we are looking to secure

So let’s build 3 scenarios at the February 9th expiration.

Scenario 1: Goldcorp continues to rally and the stock advances to $20.00 a share.

Under that scenario, I would exercise my right to buy the shares at $17.50 and would have an adjusted cost base break even of $18.15 ($17.50=$0.65).

Scenario 2: Goldcorp remains rangebound and is trading near its original starting price of $17.80 a share.

Under that scenario, I would exercise my right to buy the shares at $17.50 and would have an adjusted cost base break even of $18.15, sitting on a small unrealized loss.

Scenario 3: Goldcorp deeply retraces back towards its 2017 lows under $16.00 a share.

Under that scenario, the $17.50 call option expires at a $0.65 loss and I would be looking for a better entry price off lower levels.

To summarize, by using the call option, I have secured the right to buy the stock at $17.50, and over the next 18 days I have the right to decide if I wanted to exercise that right.  If the situation is not bullishly developing, I will walk away from the trade at a maximum loss of $0.65 a share.  This is just one of the many ways one can use options to manage and define risk.

The post Have the Tides Turned for the Troubled Goldcorp? appeared first on Option Matters.

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Once again, despite the risk of controversy, I find myself compelled to write about pot! In my last article, Embracing Volatility on a Canadian Disruptor, I looked at a couple of ways one might participate in a bullish technical pattern developing in the TSX:WEED price chart. At the time (August 28th, 2017) the shares were trading at $8.81. Since then, the stock has hit a high of $36.00, pulled back to $30.00 and is now at the time of writing pushing $42.00.

Chart: Courtesy of StockCharts.com

If we observe the price action alone, it’s easy to assume that the only way is up. Investors continue to be optimistic about the future valuation of these companies as federal and provincial governments sort out just how they will regulate both tax and distribution. That said, much of this optimism is based on speculation.

Efficient Markets

It is important to realize that in an “efficient” market, there are two sides. Investors that believe in a company’s current and future valuations who go long the stock and those that interpret the data otherwise, believing a company to be overvalued and who subsequently short the stock.

It is not unrealistic to believe that there are many investors and money managers who have a different perspective then the current “herd” of marijuana bulls. The challenge, is that shorting shares of TSX:WEED and others in the industry is not all that easy.

According to a recent article by Jenn Skerritt (Bloomberg) published in the Financial Post entitled Why it’s so difficult to bet against Canada’s Marijuana boom, “Short-selling Canadian marijuana stocks is expensive as the values of companies continue to climb and few shares are available to borrow, a key step in betting against a security. The brokerages of top Canadian banks don’t trade those stocks, and smaller firms charge prohibitive interest rates to lend them.”

The process of shorting shares of a company begins first with “borrowing” them and then selling them to an investor who believes the shares will trade higher.  The short seller collects the proceeds of the sale but has an obligation to return the shares. The short seller’s expectation is that the shares will drop in value at which point they can “buy to cover” at a lower price than what they borrowed. The profit is the difference less the cost of borrowing, and therein lies the rub.

The Cost to Borrow

In the above article, Jenner sites Ihor Dusaniwsky, head of predictive analytics for S3 Partners out of New York.  Dusaniwsky suggests (as an example) that the annual cost to borrow shares (to short) of Aurora Cannabis Inc TSX:ACB is 26%. He compares this to the 0.5% cost for most stocks that trade in the S&P 500 index.

With all that in mind, there is still a short interest in TSX:WEED. While the article suggests a decline as of mid-December, 2017, there has been a significant upswing since.

 

The Short Sellers are Mobilizing

Clearly, there are many traders and investors that are prepared to pay the cost to borrow in order to short the stock as the share value continues to defy gravity. However, my real interest in the article was the following quote by Chris Damas, editor of BCMI Cannbis Report: According to ShortData.ca, short interest is up 71.8% since December 18th (See chart left)

If you don’t have short sellers in the market, you have no ability for anyone to bet against a company plus you have no ability to hedge,” Damas said by telephone. “It directly feeds into the massively euphoric bull market we’ve had in these stocks.”

As mentioned earlier in the article, short sellers help maintain an efficient market, however, if the outlook for the industry changes, the value will drop as investors rush to sell.  This is where the options market comes in. The options market offers a means for both a bet against the underlying company as well as a tool for hedging.

Implied Vol Explosion

The expensive proposition of shorting the stock also plays in to the options market. The cost of taking a bearish stance or hedging with options has increased significantly. Back in August, implied volatility (IV) was sitting at 50%.  As of now, IV is sitting over 120%.

Chart: Courtesy of IVolatility.com

What one must realize is that the above chart is merely an average of IV across a number of strike prices and expiration dates.  A closer look at the option chain suggests that near term option contract premiums are trading at a much higher IV factored in. TSX:WEED OPTION CHAIN

So, What’s an Investor To Do?

This of course depends on the position, however, let’s assume the investor is currently holding the shares and is looking to hedge.  Given the meteoric rise in value, it is not unrealistic to want to lock those profits in.  The challenge however is that the cost of insurance (put protection) is expensive.  This is where a Collar strategy can help the investor lock in profits at a reduced price.

The Strategy

The Collar strategy involves the sale of a call option and purchase of a put option. The sale of the call creates an obligation to deliver the shares at the price specified by the strike of the contract written.  For taking on this obligation, the seller is a paid a premium. The benefit of being the seller in this situation is that you take advantage of the inflated option premiums due to the high IV.

The purchase of the put locks in the sale price of the shares should they drop in value.  The investor pays a premium to guarantee the sale of the shares at the price specified by the strike of the option contract purchased. As a reminder, 1 option contract represents 100 shares of the underlying security.

The Logistics, Part 1

Currently, the 44 strike call option, expiring February 16th 2018 has a bid of $4.95. By selling this call, the investor is obligated to deliver the shares at $44.00 anytime prior to the February 16th expiration. Note that if the shares are trading below $44.00 on the expiration date, the investor keeps the premium.

The Logistics, Part 2

This Covered Call strategy alone offers the investor a $4.95 or 11% downside buffer should the share value fall. However, for the investor concerned about a more significant drop, the addition of a put option will lock in a downside sale price should the shares fall precipitously.

To circle back to IV, the very opportunity the call seller is taking advantage of, is a liability to the put buyer.  The buyer of the put is forced to pay for the high volatility. By selling the call and collecting the premium, the intension is that the proceeds will offset the cost of the put and subsequently mitigate the cost of Implied Volatility.

Let’s assume the investor is comfortable with selling the shares at $40.00 (perhaps they purchased them at $9:00 back in August)

The current ask for the 40 strike put option expiring on February 16th is $6.20. If the premium from the sale of the call is applied, the total cost to lock in the sale of the shares at $40.00 is $1.25.

The Maximum Risk

With the shares at $42.00, the investor has the right to sell at $40.00. This right is valid regardless of how low the shares fall between now and the February 16th expiration.  As such, the maximum risk on the position is $2.00/share.  The cost to “insure” the sale at $40.00 for this time frame is $1.25.  As a result, the investor can not lose more than $3.25 on the position.

The Trade Off

The decision to sell the shares at $40.00 by exercising the put is up to the investor. If the investor wishes to continue to hold the position, the put can be sold back to the market before expiration and the call will be left to expire worthless.

The trade off comes if the shares rally above the $44.00 strike of the call. If the shares are trading above the strike of the call sold, the call seller has an obligation to deliver the shares.  As such, they “give up” any opportunity to benefit from a further share appreciation above $44.00.

Considerations

When it comes to hedging, there will always be a cost. For hard to borrow stock which limits a traders ability to short and in an industry that is unpredictable and highly volatile this cost increases significantly. With that in mind, the investor has to be more concerned about the risk of loss, and deem the cost of protection to be far less than what they may lose in a sell off., or for what they may further gain by any near term continued upside.

The post Locking In Profits on a High Flyer appeared first on Option Matters.

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As the following graph shows, the share price of Intact Financial Corporation (IFC) seems to be on a downward trend as it has just broken through its previous trough at around $104. Its stochastic oscillator (%K) and relative strength index (RSI) are also trending downward.

Since this bearish trend could take IFC down as far as $100, an investor may want to establish a hedge, writing a covered call for each 100 shares held. The price of IFC is now $103.25, so we decide to select calls expiring on April 20, 2018 with a strike of $100. This will provide us with protection at the $100 level and allow us to profit from the options’ time value decay.

Position
• Prior ownership of 1,000 shares of IFC (current price of $103.25)
• Sale of 10 call option contracts IFC 180420 C 100 at $4.50
Credit of $4,500

Profit and loss profile

As you can see in the above table, we entered March 14, 2018 as the expiration date, even though the contract expires on April 20, 2018. This is because a dividend of $0.64 will be paid on IFC shares around March 14, 2018. Since this option has an intrinsic value of $3.25, at this time the most probable scenario is that the owner of the call op-tion will exercise it just before the dividend is paid, in order to capture the dividend. Of course this will only happen if the price of IFC is above $100 on March 14. If we as-sume that it is the case, we should take the expiration date of this option as March 14, 2018. Now we can make our calculations.

This call option is in-the-money with an intrinsic value of $3.25 per share ($103.25 – $100) and a time value of $1.25 per share ($4.50 – $3.25). Selling this call gives us pro-tection against a drop of $4.50 or 4.36% to the breakeven point of $98.75 ($103.25 – $4.50). Should the share price be relatively flat or even rise rather than fall, this position could still generate a maximum profit of $1.25 per share (time value) or 1.27% for the 64-day period to March 14, 2018 (an annualized return of 7.22%) if the options are ex-ercised. So this position allows for a certain margin of error.

 
Intervention

Since we expect the stock price to decline and maybe even reach $100, we should seri-ously consider the possibility that the price could go even lower, indicating an extreme weakness of the shares. In such case, it would be appropriate to take defensive measures by buying back the call options we wrote and then write some more. Our choice of new call options will depend on how much protection we seek, and for how long.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes on-ly, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The post Writing covered calls as a hedge against a drop in the shares of Intact Financial Corporation appeared first on Option Matters.

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What better way to wrap up the 2017 year than with a market forecast.  As a trader, I always look at a forecast as establishing a baseline from which to build investment themes for the upcoming year.  The obstacle however, lies in that there is substantial herding in economic forecasting and rarely does an analyst stick their neck out with outside the box thinking. With all the emergent properties of the markets, the outcome rarely delivers on consensus expectations.  In fact, the probability of an unexpected outlier event is far more likely then anticipating the markets to remain status quo.

The purpose of publishing the 5 Potential Market Surprises for 2018 is to allow for consideration of alternative possibilities outside of consensus, and the ability to recognize if those alternative scenarios begin to emerge.

Without any further ado, the 5 Potential Market Surprises for 2018:

  1. Canadian Yield Curve Inverts. Bank of Canada has raised interest rates twice in the past year, but the middle of the curve is steepening at a much faster pace.  That doesn’t sound concerning until one recognizes that the long bonds (10-30y) have not budged.  The entire middle of the curve is converging toward 2%. It would be a potential shocker if we get an inversion in the middle of the curve as most main street analysts model a yield curve inversion as a precursor to an economic recession.
  2. Longer-term interest rates remain low and decline further. The secular lows of interest rates are likely not in. The Canadian markets need to deal with the 3 Ds (debt, demographics and technological displacement).  What a surprise it would be if the short-term inflationary and growth surge prove to be transitory based on the cyclical turn up in oil and the deflationary fundamentals drag the economy back down in the back half of 2018.
  3. The Gold Miners become the best performer in 2018. Gold miners have been one of the worst performing sectors in 2017.  While many investors chase performance and generally avoid the poor performing sectors and funds, the potential surprise could be that the contrarian buy low investor wins in 2018 with the miners outperforming all other Canadian sectors.
  4. Canadian Banks Underperform. The flattening Canadian yield curve creates a drag on bank earnings. Add to that the new B-20 rules slowing new mortgage origination and you have the right circumstances for the banks to have a cooling off period.
  5. Resurgence in Global Volatility. The last two years have ushered in a period of historically low volatility, both realized and implied. One of the major precipitating factors have been the multi-trillion-dollar central bank intervention, which is now unwinding.  The 2018 potential surprise is that as the central banks wind down their quantitative easing, the market has insufficient liquidity to pick up the slack which spurs some of the most volatile market swings since 2015.  With the TSX being strongly correlated to U.S. and international equities, the volatility spills into the Canadian stock market driving a market event.

Granted some of these events may not occur, the one thing I am certain of – using equity options in today’s low volatility environment – hedging current portfolios and leveraging potential gains may offer one of the better ways to navigate some of 2018’s choppy waters.   A perfect example of this would be the implementation of a protective collar on the Canadian bank stocks.  This involves selling a covered call and applying the proceeds to reduce the cost of buying a protective put.  If you are unfamiliar with the strategy, read the MX strategy summary.    In a period where many of these bank stocks are up 10 to 20%, using a collar to lock in those gains becomes a valuable consideration.

The post 5 Potential Canadian Market Surprises for 2018 appeared first on Option Matters.

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As you can see in the following graph, the price of shares in Franco Nevada Corp. (FNV) appears to have stabilized at around $99, just above the $95 support level, after having fallen almost systematically since November 28 when it peaked at $110.18. This decline pushed the stochastic oscillator, shown at the bottom of the graph, into oversold territory, while the RSI (Relative Strength Index) indicator rose out of its own oversold zone. This situation could signal the start of a rally of unknown strength and length. In the absence of a price objective, it is usually good practice to sell put options in order to benefit from the time decay. Since this strategy has been covered in prior articles, here we will look at buying call options in lieu of the underlying shares.

Daily Chart of FNV

As we know, the purchase of call options, and options in general, is negatively affected by time decay. This is particularly true in the case of at-the-money options, whose strike price is equal to the share price. In fact, among all the options available, it is at-the-money options that have the most time value. So the investor who wants to limit the negative impact of time decay would avoid buying at-the-money call options and concentrate instead on options that contain the least time value possible. This group includes out-of-the money call options, whose strike price is higher than the share price, and in-the-money options, whose strike price is lower than the share price. We can begin by excluding out-of-the-money options: since we have neither a price objective nor a time interval in mind, they represent too great a risk of losing the entire premium paid. All that remains is in-the-money options. The more that an option is in the money, the less time value it has, and the more that price changes in the option will be correlated with price changes in the underlying share. This is precisely what we need. We want to profit from an increase in the share price while incurring the least possible negative impact of time decay. We are therefore looking for a compromise position between these two constraints.

 
For example, consider the following call options available when FNV is trading at $98.87 on December 20, 2017:

FNV = $98.87 Intrinsic value Time value Delta
1. FNV 180420 C 92 at $10.05 $6.87 $3.18 0.72
2. FNV 180420 C 86 at $14.65 $12.87 $1.78 0.84
3. FNV 180420 C 80 at $20.00 $18.87 $1.13 0.91

Given the three call options shown above, it is option 3 (FNV 180420 C 80) that has the least time value ($1.13). Its delta of 0.91 (which can be obtained using the Montreal Exchange’s options calculator at https://m-x.ca/marc_options_calc_en.php) tells us that the price of this option is 91% correlated with the price of FNV. It is option 1 (FNV 180420 C 92) that has the most time value ($3.18), and with a delta of 0.72, its price is 72% correlated with the price of FNV. The time value of this option represents close to 50% of its premium, whereas the time value of option 3 represents less than 10%. Lastly, option 2 (FNV 180420 C 86) has a time value of $1.78 and is 84% correlated with the price of FNV. Moreover, the time value represents approximately 15% of its premium.

 
Given the fact that we do not have a price objective in mind nor a specific time interval, we should choose between options 2 and 3, or from among the options available between these two (but not discussed here). Consequently, our choice of one of these two options will be a compromise between the amount of time value, the option’s correlation with the price of FNV, and the price paid for the call option.

Intervention
Since we have no particular target price in mind, the decision on whether or not to sell the position and realize a profit will be based on any new information received from the market between now and April 20, 2018. However, if the price falls, we can immediately say that the support level of $95 should represent a stop level that, if broken through, should trigger the decision to sell the position at a loss.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The post Profiting on a higher share price for Franco-Nevada Corp. appeared first on Option Matters.

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After having peaked at $28.70 in October, the price of shares in Air Canada (AC) seems to have slipped into a short-term trough at the $22 support level. Since then, the price rallied to $26 and, as of this writing, has settled in at around $24. Prices from $22 to $28 now represent a trading range that could contain price fluctuations in AC for a while. An investor who agrees with this scenario could make the most of relatively stable prices for AC over the next few weeks by implementing a horizontal calendar spread.

Daily chart for Air Canada

Position

We build this horizontal calendar spread with put options* as follows:

    • Sell 10 put option contracts AC 180119 P 24.00 at $1.40
      • Credit of $1,400
    • Buy 10 put option contracts AC 180420 P 24.00 at $2.30
      • Debit of $2,300
  •         Total debit of $900
Profit and loss diagram

As the above graph shows, we will make the maximum profit of $835 if AC closes exactly at the strike price of $24.00 when the options expire on January 19, 2018. The position will be profitable if AC stays between the two breakeven prices of $22.15 and $26.33. The position’s maximum loss is limited to the $900 debit incurred on the ten contracts.

Intervening

Since we do not want to incur the maximum loss, we will need to take action if the price of AC reaches one of the two breakeven prices. The first type of action we could take consists of simply taking the loss by liquidating the position, and then moving on. Another approach would be to implement a second horizontal calendar spread with a price equal to the breakeven price that has just been crossed. This would push the breakeven price a bit further down and give us another opportunity to make a profit, or at least to recover part of the losses incurred on the first position. This second position will be managed like the first one, with new breakeven prices. Of course, this type of action implies taking on the risk of additional losses, so this risk needs to be considered before implementing the new position.

*Note that this horizontal calendar spread may also be constructed with call options. The profit and loss diagrams with call options are generally quite similar.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

The post A horizontal calendar spread to make the most of relatively stable prices for Air Canada shares appeared first on Option Matters.

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Investors have had a good run over the last two months as we have seen the Canadian TSX 60 index roar higher 9% from a September low of 877.00 to its highs near 955.00.  The question on everyone’s mind – is it over or is there more room to go?  Is it too late to buy or should an investor wait on the sidelines for a pullback?

This is the dilemma we investors face after such dramatic moves.  Historically, after a market move of this magnitude, a correction driven by mean reversion would commonly ensue, but I think we can all agree that there is nothing “common” about today’s markets.

The conundrum facing investors that are on the sidelines is two-fold:

  1. If the market keeps rallying and they didn’t buy, they risk remaining on the sideline indefinitely
  2. If they buy and the market mean reverts, they would have bought at the top and are now in the challenge of how to manage the losing position

This is where considering the ratio call spread is an interesting proposition.  Those unfamiliar with the strategy can review the particulars on the TMX Equity Options Strategy Summary.

The strategy is to gain upside bullish participation if there is a further sharp rise in the market, while risking very little if the market corrects lower.

Let’s build an example using the S&P/TSX 60 ETF (TSX:XIU).

  • November 27, 2017 the XIU is trading at $23.83
  • Investor sells 10 contracts of the February $23.75 calls for $0.50
  • The proceeds create a $500.00 credit
  • Investor buys 20 contracts of the February $24.25 calls for $0.25
  • The 20 contracts cost a $500.00 debit
  • The total trade is at a zero-cost outlay

The first observation to clarify is that it is not relevant to the trade if the position is open at a net credit/debit or at a zero-cost.  It just so happens that this example nets out that way.

What is the trade off from a traditional bullish position of buying call options?

The key difference is that to be profitable, you need a solid bullish continuation with the XIU advancing another 5%+ into February of next year.  A modest rally has very little benefit to the trader.

What makes the trade generally appealing over buying calls outright is that if the market was to stay the same or go down:

  1. There is little time decay impact (Theta)
  2. There is little to no loss if the XIU begins correcting lower

The max loss point in the trade lies with a modest shallow rally that only advances to $24.25 as the February expiration approaches.

Alternatively, if you are correct about a further bullish breakout, any rally above $24.75 by the expiration becomes a delta 1.00 position with unlimited upside (synthetically controlling 1000 shares).

To summarize, to utilize the ratio call spread you need a market stance anticipating considerable volatility where there is potential big upside, but an increasing downside risk.  Alternatively, if you are rather just modestly bullish, there are better strategies to consider like straight out bull call spreads.

The post Bulling the Market with a Ratio Call Spread appeared first on Option Matters.

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