When you muddle through the multitude of econometric models developed by numerous analysts, you come away with the conflicting views that the market could go up this year and that it could go down. Still, there are some certainties ahead for 2012.
One is that cash flow will be king, which means that any strategy that generates excess cash flow should be front and centre. And for options traders, this means covered calls or cash-secured puts. Another is that volatility will contract. That’s not because the world is a safer place, but because volatility was above average for so long in 2011 that a mean reversion should take it back to the centre.
Keeping with the same mean reversion thesis, banks will probably do much better in 2012. Not because there are no longer credit problems, but because most, if not all, of the bad news has already been priced into their stocks.
Take Morgan Stanley as a case in point. The market expected it to lose US47¢ a share in the fourth quarter of 2011. Instead, the company lost US19¢ a share and the stock rallied. Meanwhile, Bank of America Corp. (symbol: BAC) actually turned a profit in the fourth quarter of 2011 — and I suspect that Canadian banks will follow suit. In fact, I presume Canadian banks will do even better as they were not as bad to start with.
So, here is what we have: Cash flow is king in a lower volatility environment, and banks should begin to turn around. Taking that full circle, you might want to direct your clients into covered-call strategies on the major Canadian banks and take a look at some naked-put strategies on some U.S. banks.
As volatility is expected to abate throughout the year, you should opt for longer-term covered-call strategies to take advantage of current volatility levels. Furthermore, because Canadian banks are high dividend-paying stocks — this sector yields about twice the average for all Canadian stocks — we are further enhancing our cash flow.
Take Bank of Montreal, which was trading at $61 a share at the time of writing, as a case in point. You could buy the shares and write the July 62 calls at $2 a share. With this strategy you will receive two dividend payments totalling $1.40 a share plus the $2 a share option premium. And if you are forced to sell the shares to the call buyer in July, you will sell your shares at $62, which is $1 a share above the current price.
In total, should the stock be called away in July, you would have earned $4.40 a share in cash flow and capital gains over the next six months. That equates to a 7.2% return on investment should the shares be called away. And if the shares remain where they are, you would still earn $3.40 in cash flow for a return of 5.6%.
It’s the same story for the other Big Five Canadian banks. The returns for this strategy through July all equate to around a 6% to 8% return. They all produce above-average cash flow, and if the shares are called away, you have capital to redeploy at the mid-year point.
Now for the U.S. Many of the money centre U.S. banks are not paying dividends. That’s the fallout from the subprime mortgage crisis, during which the U.S. federal government put in place restrictions on the dividends the “too big to fail” group could actually pay out to shareholders.
Furthermore, if you were to buy U.S. banks, you have currency risk. Should the U.S. economy start to pick up steam, we could see a spike in the U.S. dollar, but we could also see some downside in the greenback as well. That’s another layer of uncertainty that you probably don’t need at this stage of the recovery.
With that in mind, you should opt for selling naked puts. The strategy has the same risk/reward characteristics of the covered call, except that with the naked put, you are taking on an obligation to buy the shares at the strike price at some point during 2012.
Again, look for longer-term naked puts to take advantage of current volatility levels. With that in mind, look at BAC, which was trading at US$7.15 a share at the time of writing. With BAC, look at writing the August 7 puts at US95¢ a share or better.
With this trade, you are agreeing to buy BAC at US$7 a share until the August 2012 expiration. If the stock is below US$7 a share in August, the put will be exercised and you will buy the shares — but the out-of-pocket cost is US$7 a share minus the US95¢ premium received. But if the stock is above US$7 in August, the puts will expire worthless and your total return is calculated as the premium received (US95¢) divided by the obligation assumed (US$7 a share). The total seven-month return would equal 13.6%.
So, if you are buying into the view that 2012 will be a relatively flat to slightly higher year with less volatility, cash-flow strategies should take centre stage. The bottom line: look for stocks with above-average dividend yields, covered-call strategies to enhance cash flow and for a small bet on the U.S. recovery, naked put writes on large money-centre U.S. banks. IEwhen you muddle through the multitude of econometric models developed by numerous analysts, you come away with the conflicting views that the market could go up this year and that it could go down. Still, there are some certainties ahead for 2012.
One is that cash flow will be king, which means that any strategy that generates excess cash flow should be front and centre. And for options traders, this means covered calls or cash-secured puts. Another is that volatility will contract. That’s not because the world is a safer place, but because volatility was above average for so long in 2011 that a mean reversion should take it back to the centre.
Keeping with the same mean reversion thesis, banks will probably do much better in 2012. Not because there are no longer credit problems, but because most, if not all, of the bad news has already been priced into their stocks.
Take Morgan Stanley as a case in point. The market expected it to lose US47¢ a share in the fourth quarter of 2011. Instead, the company lost US19¢ a share and the stock rallied. Meanwhile, Bank of America Corp. (symbol: BAC) actually turned a profit in the fourth quarter of 2011 — and I suspect that Canadian banks will follow suit. In fact, I presume Canadian banks will do even better as they were not as bad to start with.
So, here is what we have: Cash flow is king in a lower volatility environment, and banks should begin to turn around. Taking that full circle, you might want to direct your clients into covered-call strategies on the major Canadian banks and take a look at some naked-put strategies on some U.S. banks.
As volatility is expected to abate throughout the year, you should opt for longer-term covered-call strategies to take advantage of current volatility levels. Furthermore, because Canadian banks are high dividend-paying stocks — this sector yields about twice the average for all Canadian stocks — we are further enhancing our cash flow.
Take Bank of Montreal, which was trading at $61 a share at the time of writing, as a case in point. You could buy the shares and write the July 62 calls at $2 a share. With this strategy you will receive two dividend payments totalling $1.40 a share plus the $2 a share option premium. And if you are forced to sell the shares to the call buyer in July, you will sell your shares at $62, which is $1 a share above the current price.
In total, should the stock be called away in July, you would have earned $4.40 a share in cash flow and capital gains over the next six months. That equates to a 7.2% return on investment should the shares be called away. And if the shares remain where they are, you would still earn $3.40 in cash flow for a return of 5.6%.
It’s the same story for the other Big Five Canadian banks. The returns for this strategy through July all equate to around a 6% to 8% return. They all produce above-average cash flow, and if the shares are called away, you have capital to redeploy at the mid-year point.
Now for the U.S. Many of the money centre U.S. banks are not paying dividends. That’s the fallout from the subprime mortgage crisis, during which the U.S. federal government put in place restrictions on the dividends the “too big to fail” group could actually pay out to shareholders.
Furthermore, if you were to buy U.S. banks, you have currency risk. Should the U.S. economy start to pick up steam, we could see a spike in the U.S. dollar, but we could also see some downside in the greenback as well. That’s another layer of uncertainty that you probably don’t need at this stage of the recovery.
With that in mind, you should opt for selling naked puts. The strategy has the same risk/reward characteristics of the covered call, except that with the naked put, you are taking on an obligation to buy the shares at the strike price at some point during 2012.
Again, look for longer-term naked puts to take advantage of current volatility levels. With that in mind, look at BAC, which was trading at US$7.15 a share at the time of writing. With BAC, look at writing the August 7 puts at US95¢ a share or better.
With this trade, you are agreeing to buy BAC at US$7 a share until the August 2012 expiration. If the stock is below US$7 a share in August, the put will be exercised and you will buy the shares — but the out-of-pocket cost is US$7 a share minus the US95¢ premium received. But if the stock is above US$7 in August, the puts will expire worthless and your total return is calculated as the premium received (US95¢) divided by the obligation assumed (US$7 a share). The total seven-month return would equal 13.6%.
So, if you are buying into the view that 2012 will be a relatively flat to slightly higher year with less volatility, cash-flow strategies should take centre stage. The bottom line: look for stocks with above-average dividend yields, covered-call strategies to enhance cash flow and for a small bet on the U.S. recovery, naked put writes on large money-centre U.S. banks. IE