Bear in the woods or bull in the ring?

Stock markets declined steeply on the week as the fear factor took its toll. The S&P/TSX Composite Index retreated 6.0% week-over-week, mainly on a slide in commodities, led by crude oil, which dropped to near US$85 per barrel, before recovering to US$87 by Friday’s close.

In New York, the Dow Jones Industrial average lost 5.7% on the week, and the S&P 500 Composite retreated 7.2% on fears that a faltering US economy would depress earnings through the second half.

So, with the CBOE Volatility Index (VIX) at 32, is a bear crashing around in the woods? Is it time to abandon hope, sell stocks, and move into cash, which yields… nothing? Not so fast.

While stock markets have stepped into correction territory, there is much to commend them. Indeed, many analysts might look at this correction (which incidentally had been predicted by a number of pretty smart domeheads) as a classic buying opportunity. And some are looking for a significant stock rebound in the second half, with outfits like Credit Suisse Group AG and HSBC Holdings Plc advising clients to buy in anticipation of a rally in the S&P 500 of as much as 16% from current levels by the end of the year.

With nearly all S&P 500 companies having reported quarterly financials, both corporate revenue and earnings are up 13% from the same period a year ago, according to Yardeni Research. What’s more, the S&P 500 forward price/earnings ratio is around 13, below the long-term average of 16. A number of analysts have raised earnings estimates for the S&P 500. Strong earnings and estimates often combine with low (oversold?) prices for a potentially good buying opportunity.

Bold options investors who are willing to bet on a bull in the ring rather than a bear in the woods might consider bullish positions in the broad stock market indexes, best approached through large, liquid exchange-traded funds.

For Canadian stocks, two strategies come to mind; call buying and selling cash secured puts on the iShares S&P TSX 60 Index Fund (TSX: XIU, Friday’s close $17.36). With the decline in the market last week, volatility levels spiked by 35% on the CBOE Volatility index and about 20% on the S&P TSX VIX Index. Higher volatility means higher option premiums.

If you believe that premiums are overstating the current risk in the market, you could sell the volatility through cash secured puts. For example, with iShares S&P/TSX 60 Index Fund (TSX: XIU, Friday’s close $17.36), you could write the XIU September 17 puts at 50 cents. If XIU remains above $17 through the September expiration, you retain the premium received.

If you are slightly more aggressive, you could look at writing the in-the-money XIU September 18 puts at $1.00. With these puts XIU will have to rebound and be above $18 at the September expiration. In the best case scenario, you would retain the $1.00 in premium received.

By definition, “cash secured” means that you have sufficient cash in your account to buy the underlying security should the put be assigned. In the first example, you would hold $1,700 in cash for every XIU September 17 put written. In the second example, you would retain $1,800 for every XIU September 18 put written. In both cases you can use the premium received as part of your total cash position.

The second strategy is to simply buy calls if you believe the markets will rebound sharply. The XIU October 17 calls at $1.00 would be one strategy. Another would be to purchase in-the-money calls. With XIU, you could buy the October 15 calls at $2.65.