Options strategies for the new year

Looking at things from the other side, we see beaten-down subindices, such as the S&P/TSX capped metals and mining subindex (down by more than 30%), the S&P/TSX global mining subindex (-26.4%), the S&P/TSX capped materials subindex (-23%) and the S&P/TSX capped energy subindex (-21.9%).

As we begin 2012, you could argue in favour of the beaten-down sectors. Certainly, reversion to the mean could play a role in 2012, in that sectors that had performed badly in 2011 could come back to life. If nothing else, you should ask how much longer this can go on.

If you look only at the raw data on which analysts rely and from which they try to draw conclusions, then the underperformance could last for some time — particularly when looking at commodities. Should the eurozone crisis continue to influence global economic activity — and there’s no reason to believe it won’t — commodities prices could drift lower in the first half of 2012.

China is not helping matters, either. It is contending with a slowdown in growth as its main European export market shrinks, which may not be a bad thing for China’s central planners — especially when you consider that the power brokers in China are concerned about a domestic real estate bubble that looks ominously similar to what led up to the 2008 U.S. subprime mortgage crisis. The point is that any natural slowdown in China may mitigate some of the problems that could cause far more grief down the road.

Taking that thesis full circle, the impact of a slowdown in China will be felt in Canada because much of our raw material ends up in China, and reduced demand implies a direct hit on Canada’s vast resources sector. China is trying desperately to avoid a hard landing for its economy (which most analysts define as growth below the 7% threshold in China’s case). If that happens in the next fiscal quarter or two, Canada’s already beaten-down resources companies are likely to get beaten down even more.

The problem that financial advisors face is trying to decipher how much of that potential bad news is already baked into the numbers. Given the stock market’s predilection to predict the future rather than react to the present, there is a case to be made that the underperformance in 2011 is the direct result of the uncertainty leading into 2012.

The trick is to hedge your bets by taking advantage of the things we know. For instance, we know that anxiety is likely to remain high in 2012. We also know that anxiety leads to more volatility. And we know that the options market quantifies volatility by making traders pay a higher price for puts and calls.

We also know that the Chicago Board Options Exchange’s volatility index has been declining in recent weeks, which seems to suggest that traders have been willing to engage in “risk on” trades, which are larger bets in the equities markets. However, that may change in the early going of 2012, as hedge funds begin to gear up by providing a little more headwind to the “risk on” trade.

Given this view, your clients might consider buying calls on some of the aforementioned beaten-down sectors. If stability does return to the markets — i.e., the eurozone begins to untangle itself from its liquidity crisis and China is able to engineer a soft landing — the underperformers may do quite well. At least, the calls limit your risk and, with volatility at the lower end of its recent trading range (i.e., options premiums are at the lower end of their range), the cost is reasonable.

If, on the other hand, equities markets start 2012 on a wild roller-coaster ride, options premiums will quickly reflect the higher volatility. At this point, you could exit the long call positions and replace them with option-writing strategies — say, writing covered calls on the better performing sectors or writing longer-term puts at higher implied volatilities (i.e., write puts that expire in the late summer or early autumn) in the commodities and/or energy space. IE