A strategy for optimism

Earlier in the year, good economic news was viewed as being bad for stocks, and vice versa. At one point, the fixation related to employment data, in which traders viewed weak job creation as a positive. High unemployment inferred the U.S. Federal Reserve Board’s support for continued quantitative easing (QE III).

Now, that’s not so much the case. Rather, stock markets are warming to the concept of “tapering” and the attendant implications. But, more important, as we enter the QE III endgame, traders now are in a position to make decisions based on a purist interpretation of the data – in which good news is good and bad news is bad.

If markets are less fickle, then financial advisors are in a better position to offer investment recommendations tied to economic fundamentals rather than to emotional hyperbole. Further volatility, which is still slightly above average, should normalize over time. (Normalized volatility is based on the 200-day moving average for the Chicago Board Options Exchange’s volatility index.) This means that options premiums written at today’s implied volatility should contract over the ensuing months.

Therein lies the rationale for covered calls, as traders can collect premiums that are elevated based on current volatility metrics and watch those premiums contract as “normal” modelling becomes engrained in the investor psyche.

Furthermore, covered calls will cushion what is sure to be a bumpy transition toward this new norm. Thus, your clients should write covered calls on blue-chip stocks with solid dividends and pay particular attention to financials because higher interest rates have a beneficial impact on their net interest margins.

Still, transitions are rarely seamless, particularly with the abundance of risk associated with other geographical regions – most notably, the eurozone, which remains entrenched in a double-dip recession.

If history has taught us anything, it’s that traders are not able to turn off raw emotions barely below the surface. Seismic economic shocks will affect sentiment, which will create short-term distortions in valuations.

So far, the peripheral sleeping dogs have not affected traders. Stocks in both Canada and the U.S. remain in rally mode – and are likely to continue to do so throughout the second-quarter earnings season. This means that sell-offs resulting from unpredictable macroeconomic events should be short-lived and, most likely, will serve as buying opportunities.

Finally, there is a longer-term thesis that supports this subtle shift toward optimism. U.S. stocks began to rally in earnest on the heels of the June U.S. employment report, which cited the creation of 195,000 jobs. Although this is not a robust number, it’s enough to support the current “slow, sustainable recovery” thesis. Until that view changes, this thesis and the accompanying earnings spotlight will be primary drivers for U.S. stocks. And, ultimately, what’s good for the U.S. will be good for Canadian exports.

The covered-call strategy will be advantageous as these scenarios unfold. The premium collected takes advantage of above-average volatility levels, which should eventually normalize. Your objective should be to generate excess cash flow for your clients by collecting premiums, which should find their way into your client’s yearend performance numbers.

Furthermore, the covered-call strategy will be useful when seismic shifts push stocks lower, creating a spike in volatility. Viewing that scenario as a buying opportunity allows clients to acquire stocks at lower prices while writing covered calls that take advantage of any spike in volatility.

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