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.

Brexit is a Reality

By Richard N. Croft

Brexit is a reality! Despite the betting odds, despite the financial markets’ expectation that we would see a “remain” outcome, the British electorate knowing for bucking the odds voted to exit the European Union.

And now we face the inevitable fallout. Unfiltered headline noise will set the stage this week. Witness the latest hot off the press headline noise; “Financial Markets in Free Fall;” “Volatility is Spiking;” “Gold is Surging;” “Currencies are in Disarray!” Remember this is noise and not what you should focus on when making investment decisions.

Fact is Canadian equities as measured by the iShares S&P/TSX 60 Index Fund (symbol XIU) fell 1.93% on Friday which puts the index back to where it was a week ago. The so-called spike in volatility is well below levels in February (the MX VIX Index closed Friday at 20.06, it closed as high as 31.99 in February this year). Gold is higher but not as much as you might think and is still well below levels from 2012 through 2014. Gold bugs are not seeing this as the global crisis that financial writers and doomsayers like to espouse.

The currency market is another story. The decline in the British Pound was monumental, clearly uncharted territory! And there may be more to come. Britain will most likely slip into a recession which may prompt Mark Carney head of the Bank of England to cut rates. Best guess is a snap 25 basis point cut which may further weaken the pound.

I believe the longer term implications will be political than economic. British Prime Minister David Cameron orchestrated this vote based on a promise he made to parliament in 2013. It was designed to appease members of his own party who felt that Britain gave up too much in negotiations with the EU. The lesson from this is that referendums don’t work well when dealing with complicated positions. Too often the economic message gets lost under the weight of political biases that gravitate to the lowest common denominator. In this case the leave camp played on the electorates’ xenophobia about lax immigration policies, unprotected borders and jobs. If you think that’s not the case watch closely as the US Presidential race heats up. It will play to the same storyline.

The trick in the weeks ahead is to separate the political meat from the skeleton. For example, the Scottish Parliament fresh off their own referendum that voted to remain within Britain mainly because doing so allowed Scotland unfettered access to the Eurozone, will probably introduce legislation to prevent the British parliament from enacting article 50 (the article that provides the process for exiting the Eurozone) with Scottish consent. It won’t matter but that will likely lead to another Scottish referendum to leave Britain which may well pass.

Northern Ireland will attempt to succeed from Britain to join Ireland which is an EU member. That will not likely pass muster with the Protestant majority in Northern Ireland, but will nevertheless be fodder for more headline noise.

Conspiracy theorists will say that the British exit will lead to more separations within the Eurozone. That’s not likely with the possible exception of Hungary. But that will have more to do with the political system. Hungary is a dictatorship and under the rules, only democracies can be members of the Eurozone. As for Italy, Spain or Greece, if they were going to leave they would have done so already.

I suspect that reality will begin to set in by mid-week. Any exit plan will take two to three years to implement. Most likely Britain will negotiate a partial union much like currently exists for Norway which pays about US $1 billion in annual dues to have access to the Eurozone. Norway must follow Eurozone rules but as a country remains independent.

As cooler heads prevail we may well see a rebound in equity markets once hedge funds and institutional portfolio managers have reset their portfolios based on revised earnings expectations. Which by the way will start to replace the headlines starting in July.

At this stage I would avoid committing serious money to hedging strategies. I think most of the damage has already occurred. Wait for opportunities to begin nibbling at new positions which could come as early as mid-week.

By Richard N Croft