Managing Risk

By Richard N.Croft

There are many factors one should think about when making specific investment decisions. Momentum, sentiment, fundamentals, quantitative metrics, value models… the list goes on!

That said successful traders share a common thread. They have established principles for selecting the right stock, strategy or position and are able to manage risk once the position has been established.

It comes down to a recognition that financial markets reward different strategies at points along the business cycle. Sometimes covered calls make the most sense, other times buying calls is the preferred strategy. Volatility trades make sense when volatility troughs or expands dramatically. Leverage is useful at certain stages while other times hedging is a better approach.

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Expected Return: A statistical concept with a real world application

By Richard N. Croft

It is difficult to make money trading options. If you doubt that statement, you probably haven’t been trading long enough.

Of course recognizing that it is difficult to make money should not cause you to avoid a market altogether. The trick is to mitigate as much as possible your losses, by utilizing option strategies that generally have higher than normal expected returns.

Before getting into this concept it is important to understand there is a big difference between expected return and actual return. Expected return is a statistical concept that applies to the return one would expect on a specific strategy over a large number of trials.

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The ETF Option Advantage

By Richard N. Croft

When most investors think about option writing strategies, they think about writing calls against individual stocks. Buy shares of BCE, Suncor or Royal Bank and sell covered calls.

While not as popular, covered call writing against exchange traded funds offers some interesting twists for lower risk investors. One notable advantage is diversification
which reduces non-systemic risk. That being the risk unique to individual companies. Transportation margins which depend on fuel prices, minimum wage issues for fast food restaurants, regulatory change a within the financial sector, etc.

Company or industry-specific hazards that are inherent in single stocks or sectors must be factored into the investment decision. But typically, such factors are unpredictable. Non-systemic risk, also known as “company specific risk,” “diversifiable risk” or “residual risk,” can be reduced through diversification. An ETF like the iShares S&P TSX 60 Index Fund (symbol XIU, Fridays’ close $20.56) spread across many sectors being the ultimate diversifier within an asset class.

If we broaden the concept, owning other assets such as bonds, preferred shares, real estate and alternative strategies can reduce non-systemic risk in a portfolio.

Coming full circle investors must recognize that the unpredictable nature of non-systemic risk means that by extension, it cannot be quantified effectively by the options market. The premium one pays to buy or receives when selling an option, is really a function of how much risk traders believe there is in the underlying security. On an individual stock, there is really no way to assess company specific risk which means that stock option premiums often understate the real risk within an individual stock. With an ETF you do not have to evaluate company specific risk, only sector risk – in the case of a sector ETF – or market risk – in the case of broader market indices.

ETFs also have limited downside. Whereas individual companies can go bankrupt, ETFs cannot, effectively eliminating zero as the worst case scenario. Also index option premiums typically overstate the risk in specific ETFs. Historically, the volatility implied by options on XIU almost consistently overstate the actual volatility displayed by the ETF. Which is to say XIU options are almost always overpriced.

Supporting that position is the historical performance metrics with the Mx Covered Call Writers (MCWX) Index. MCMX is simply an index that examines the returns generated by regularly writing one month calls on a long position in XIU. Data back to 1992 shows that the XIU call options have regularly overstated the actual volatility associated with a buy and hold strategy on XIU. Meaning that MCMX has consistently outperformed buy and hold on a nominal and risk adjusted basis.

Never was that more evident than during the financial crisis. ETF option premiums expanded dramatically, which provided an effective hedging tool for investor employing covered call writing as a strategy.

Today as investors have become more complacent option premiums have contracted. Note the Canadian Volatility Index (symbol: VIXC) which measures the implied volatility on XIU options, closed Friday at 13.07%. During the first quarter of 2008 that number was in the mid-20% volatility range.

If you are inclined to write covered calls against broad market indices, consider buying shares of the XIU and writing close to the money three to six month calls against the units.

More aggressive traders might consider writing covered calls against sector indices using ETFs like iShares S&P/TSX Global Gold Index ETF (symbol XGD) or iShares S&P/TSX Capped Energy Index ETF (symbol: XEG). The trick is to ensure that you choose sector indices that you have a feel for and that have sufficient liquidity to allow movement in and out of positions.

To that latter point look at the open interest and volume numbers for the individual options. Being able to pick the direction of a specific ETF will only produce a profit if you are able to enter and exit positions with minimal bid ask spreads.

Writing options against ETFs is not as exciting as writing calls against individual stocks. However, considering that many individual stocks have been driven almost exclusively by non-systemic risks and knowing that individual stock options are relatively cheap (i.e. understating the impact of non-systemic risk), writing covered calls against ETFs may prove to be the superior strategy through the end of this year.