Wednesday, January 04, 2006

Time is Right to Buy Options on Cdn Banks

But conditions this year provide a classic case study on when not to write options against your portfolio

Investment Executive, Richard Croft, 4 January 2006

Option premiums remain at or near 10-year lows, at least if we use as our proxy the Chicago Board Options Exchange volatility index (VIX) or the Montreal Exchange implied volatility index. The former measures implied volatility using options on the Standard & Poor’s 500 composite index; the latter measures implied volatility using options on the S&P/TSX 60 index.

The VIX closed Nov. 18 at 11.12%, which is well below the 200-day moving average of 13.75%. We tend to look at the 200-day moving average because it is a better measure of the trend in option premiums, and can be used as a proxy for fair value. Similar numbers can be found in Canada, as the Mx implied volatility index is at 14.1%.

The disparity between so-called “fair value” and the actual level of option premiums provides an interesting case study of why investors need to look at more than just one strategy when trading options.

We know, for example, that covered call writing is a reasonable long-term strategy. It can lower the risk associated with a buy-and-hold strategy. And over the past 15 years, both in Canada and the U.S., covered call writing as a strategy (before factoring in transaction costs) has actually outperformed buy-and-hold.

I cite the long-term performance of the Mx covered writers index. This is a passive option writing index that assumes an investor holds a long position in the S&P/TSX 50 iUnits and writes one-month, at-the-money calls against the shares. As each option series expires, the short option is settled in cash, and a new one-month, at-the-money call option is written.

Since December 1993 — the starting date — the Mx covered writers index has returned 10.36% compounded annually, vs 8.93% compounded annually for the S&P/TSX 60 iUnits. Neither the Mx covered writers index nor the S&P/TSX 60 iUnits accounts for dividends that would have been collected along the way. Moreover, the Mx covered call writers index has an annual standard deviation of approximately 11.91% vs 16.78% for the S&P/TSX 60 iUnits. Bottom line: covered call writing has, on a long-term basis, delivered better returns with less risk.

However, there are periods when covered call writing actually detracts from portfolio performance. This is particularly true in a choppy market environment with low premiums.

This year is a classic case study of when not to write options against a portfolio. Looking at the performance of our two proxies in 2005, the S&P TSX 60 iUnits are up 17.4%, compared with 2.49% for the Mx covered call writers index. To state the obvious, Canadian-based strategies that involve covered call writing have not fared well in 2005. And the main culprit is low option premiums.

In such an environment, as I have said in this column on more than one occasion, buying options makes sense at this stage in the market cycle. And I continue to believe that option-buying remains the strategy of choice.

There are a couple of ways to play this. The first approach is obviously to buy calls or puts on companies toward which you have a bias, either bullish or bearish. The second approach is simply to buy straddles on either the S&P 500 index (if you want to play the U.S. market) or the S&P/TSX 60 iUnits (if you want to play the Canadian market).

The key to any directional trade is to be right about the direction the underlying stock is about to move. Equally important is making certain not to overpay for the options. This point may seem counterintuitive, as I have just said that option premiums are cheap. But, as with any investment axiom, there are caveats. Options are cheap when you look at the cost of options on the broad market as measured by either the VIX or the implied volatility for options on the S&P/TSX 60 index.

But not all sectors of the market have cheap options. Energy stocks, for example, have been more volatile than the general market, making options on energy stocks generally more expensive. The same is true of options on gold stocks, although not to the same extent. On the flip side, options on financial services companies, particularly Canadian banks, are inexpensive, both in nominal terms and relative to the options on the broad market.

This suggests that buying calls or puts on energy stocks means a more significant move will have to occur in order to overcome the cost of the option. Not impossible, to be sure, but certainly challenging, especially given that we have already had significant moves in the energy sector.

On the other hand, buying calls — assuming a bullish bias — or puts — assuming a bearish bias — on bank stocks has a higher probability of success. It is quite probable, given how inexpensive bank options actually are, that the share values will move enough to cover the cost of the option.

Personally, I like the idea of buying calls on Canadian banks, for a number of reasons.

First, banking is a risk-management business that tends to follow the general direction of the economy. If we see a boost in the U.S. economy as a result of rebuilding efforts after two major hurricanes, stocks will rally. In that scenario, banks will rally and, because options on banks are cheap, the leverage will enhance the position more positively than would be the case if you were long options on a sector in which premiums were more expensive.

On the other hand, if we get a sell-off in the equity markets in 2006, which could happen if U.S. consumers become shell-shocked because of the high cost of heating oil and natural gas, equity investors may run for cover. In that scenario, banks are an attractive alternative with a high dividend payout.

Finally, if oil prices begin to subside or at least stabilize in, say, the mid-US$50s per barrel, energy stocks may fall slightly. And that also could cause some investors to move money out of energy and into, say, gold and perhaps — dare we say it? — financial services.

Because of the possibilities and because of the fact that options on banks are inexpensive, buying longer-term calls on any of the major Canadian banks may turn out to be an excellent low-cost option-buying opportunity.