A Synthetic Long Stock Strategy For Canadian Banks

Canadian bank stocks have been somewhat unfavorable this year. Concerns about the Canadian economy, the impact of low oil prices and the pressure on lending margins from lower interest rates have had many investors questioning just how much more upside can be expected.

The chart below is a snap shot of the weekly price action for ZEB.TO which is the BMO S&P/TSX Equal Weight Banks Index ETF. Note the significant volatility in price action from December 2014 to present. The technical pattern that has developed is known as a sideways triangle. This pattern forms as a result of highs getting lower as indicated by the upper trend line and lows getting higher as indicated by the lower trend line

This pattern is associated with indecisiveness. After all, an uptrend will consistently make higher highs while a down trend will consistently make lower lows. Based on a current analysis of the chart, we have seen neither higher highs nor lower lows. This suggests that investors are just not sure what direction the banks are heading.

Now, despite positive second quarter earnings in May, we have seen the banks largely sell off for the last several weeks. That said, if we take a look at the ZEB.TO chart on a daily time frame, we can see that prices may be starting to break higher.

Bullish Observations

1. Break above the 200 bar moving average. While this is not necessarily a guarantee of a continued bullish trend in banks, it does bring the price back above it’s long term trend line
2. Bullish flag pattern that indicates a possible continuation higher

So how can we take advantage of this?

Let’s assume that an investor wants to lock in today’s price just in case the shares take off. On the other hand, if the shares pull back further, they are happy to own ZEB.TO shares at a lower price. One strategy that they can use is a variation of a synthetic long stock position using options. By definition, a synthetic long stock position involves the purchase of an at-the-money call option while selling an at-the money put option. The credit from the written put offsets a portion of the purchased call and the risk on the positions is comparable to owning the stock itself.

My variation would have the investor purchase a slightly in-the-money call, but sell an out-of-the-money put. The long call offers the investor an opportunity to benefit from an immediate rise in the stock and the right to purchase the shares at the strike selected, regardless of how high the shares trade. However, to offset the cost of this option and lower the break-even point, we can sell the out-of-the-money put and collect the premium. The reason an investor would consider selling the put at a lower strike is because they are willing to own the shares at that price if ZEB.TO sold off.

The Trade

With shares of the ZEB.TO trading currently at $22.75

BUY December 22 strike CALL – $1.30 debit
SELL December 20 strike PUT – $0.30 credit

Net Debit = $1.00

The investor has the right to own the shares at $22.00 and has reduced the cost of the long call position to $1.00. The Break even on the upside is now $23.00. With the shares at $22.75, the position is only $0.25 away from break even.

If the shares drop in value, the investors risk is limited to the $1.00 net cost until the shares are trading at or below $20.00. At that point, the investor may be assigned and will take possession of the shares at $20.00. The break even on the position would be $21.00 based on the original cost. Once the investor takes possession of the shares at $20.00, the risk is unidentified. Bare in mind a covered call may be written or a protective put purchased at that point to help mitigate the risk.

Daily Chart
2 Year Time Frame

In Conclusion

This strategy offers the investor who wants to own the stock the best of both worlds. If the shares take off, the 22 strike call guarantees the investor the right to own ZEB.TO at $22.00 regardless of how high the shares trade. The investor would also have the choice to sell the call for a profit instead of buying the shares if they were satisfied with the move.

If ZEB.TO drops in value, the investor has the opportunity to own the shares almost 10% lower, but must be aware of the unidentified risk once they have taken possession of the shares.