The outlook for the weakening economy comes right from the top, where the Bank of Canada came out with its rate statement on March 6. The BoC took a dovish stance, making it clear that, not only are rate hikes on hold, but rate cuts would be considered if the economy started to deteriorate. Such a dovish pivot by our central bank governor can only represent the growing concerns of a weakening Canadian economy. Couple that with a Canadian housing slump—as we are experiencing a first drop in values in decades—and WTI crude oil prices trading near $60 a barrel (at the time of writing), it becomes harder to look at the glass as half full.
To the surprise of many pessimists, the Canadian stock market remains resilient, trading just a few percentage points below its all-time highs. Where is the disconnect? Interestingly enough, throughout history, the correlation between the economy and stocks is surprisingly divergent with some of the strongest performances occurring when the economy was just muddling along.
So, should investors disregard this current muddled market environment and stay fully invested? Possibly yes. But at the same time, these economic conditions often exist just prior to a recession which can usher in a bear market.
So what can a Canadian investor do?
Raise cash and rent the upside of the market by using call options. Very few times has it been cheaper and more appropriate.
One of the best ways to demonstrate the point is to observe the VIXC, which measures the 30-day implied volatility of the Canadian stock market using the S&P/TSX 60 index options. On the chart above, you can observe that beyond very short-term surges, the level 10 on the index has been the lower boundary. The lower the volatility, the cheaper the option price, as it is pricing in a smaller expected range for the index.
So how does the strategy (renting the upside) work and is it right for you?
In this example, we have:
- An investor who owns 1000 shares of the S&P/TSX60 Index ETF (XIU)
- XIU is trading at $24.42 (April 2, 2019)
- The September 20, 2019, $22 call is trading at $2.62 ($0.20 of time value; $2.42 of intrinsic value; delta = 0.8201)
Our investor proceeds to sell their 1000 shares of XIU and raises $24,420 in cash. This is even more ideal in a registered account as it would not trigger a taxable disposition.
The investor then proceeds to buy 10 contracts of the September 20, 2019, $22 call options for $2.62 per option or $2,620. The remaining $21,800 in cash ($24,420 – $2,620) is safely set aside in an interest-paying money market fund.
It is important for an investor new to trading options to recognize that by buying the $22 call strike (the right to buy the shares at $22.00), our investor has synthetically purchased $2.42 of the stock (9.90% of the underlying). For this, the cost to rent the shares through the options was $0.20 in time value, or $200.
What is the outcome? Let’s discuss two scenarios.
First scenario: The Canadian stock market continues to rise. In this case, come September, our investor can simply exercise the call option and buy in the 1000 share positions at $22.00 +$2.62 ($24.62 breakeven).
Second scenario: The S&P/TSX 60 proceeds to drop 20%,
exceeding the lows back in December 2018. Our investor’s loss is
limited to the $2.62 premium as the option would expire with no value.
While the option would expire for a 100% loss, the investor is only
materializing a loss of 10.72% of the cash proceeds from the sale of
the original XIU shares. More importantly, the investor has the cash
on the sidelines to buy the dip on the markets for the recovery.
The key takeaway, using this technique, is that our investor can continue to bullishly participate on the upside of the markets knowing that if a bear market/recession were to materialize, the majority of their investment is in cash and their maximum loss is clearly defined. In this case, spending the $200 of time value to rent the upside of the market while limiting the maximum loss to 10.72% (of the cash proceeds) may be a worthwhile investment in the current market conditions.
By Patrick Ceresna , Derivatives Market Specialist
Big Picture Trading Inc.
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