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Buying on a Pullback?

Richard Croft
September 24, 2012
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Your psyche is torn… Central banks have a plan, and they seem to be implementing it. The ECB is willing to purchase unlimited amounts of sovereign debt to prevent a default / re-structuring / bailout / or insert nomenclature here, which effectively keeps the EU intact.

Not to be undone, the US Federal Reserve is providing unlimited liquidity through its version of QE3. The intent is to prevent the US economy from slipping into a double dip recession by encouraging investors to seek “risk on” trades.

The Fed is attempting to set a floor under the equity markets while guaranteeing that investments in low risk assets – i.e. cash and short-term bonds – result in a loss of purchasing power.

If the ECB is successful it should prevent further damage to the euro while the Fed’s unlimited use of QE3 should prevent the US economy from slipping into a double dip recession. If QE3 sparks US growth that should restart emerging markets which theoretically, would have a meaningful impact on global growth.

Mind you this is all conjecture. There is no precedent for this kind of bailout and we have not been presented with “too big to fail” alternatives should things not go as planned. Most traders suspect that the EU and Fed are crafting workarounds on the fly.

The goal is to manage investor psyche. Instinctively investors do not want to fight the Fed. But those same investors are aware that October – a month when a lot of bad things tend to happen – is around the corner and the market is at or near 52-week highs. Efforts to encourage risk taking in this environment is akin to attaching a bungee cord to someone and asking them to jump from the top of the CN Tower!

Analysts are not likely to help either. Having witnessed a sizeable rally in the market most analysts will invoke a series of well rehearsed double speak laced with caveats when talking to the financial press or investors. An excellent cross over line is something like; “I am constructive on the market but would like to see a pullback before jumping in!” Nothing that will likely alter investor sentiment.

Perhaps the answer is to look at a cross over strategy. An approach that allows you to dip your toes in water filled with caveats. A middle of the road strategy like cash secured puts where you get paid to assume an obligation to buy securities on a pullback.

When you sell a put option you are accepting an obligation to buy the underlying security at a specific price. Presumably if you are in the “buy-on-a-pull-back” camp you want to enter at a price that is lower than current market values.

Canadian energy companies make interesting case studies. In recent weeks, the price of oil and attendant performance of energy stocks have had a low correlation to the broader market.

But if you believe in a positive EU outcome and accept that a double dip recession in the US is off the table, energy stocks could be the sector to trade on a pullback. Examples include major Canadian energy producers like Suncor (TSX: SU, recent price $32.99) and Imperial Oil Ltd. (TSX: IMO, $45.99).

If you like the sector on a pullback, write the SU March 32 puts at $2.05 per share. The sale of this put obligates you to buy Suncor at $32 per share until the third Friday in March (i.e. the last day of trading for March 2013 options).

If the puts are assigned your actual cost to buy SU is $32 less the $2.05 per share premium received, which equals $29.95 per share. That is approximately 10% below the current market price.

Similar strategy with IMO where you sell the February 44 puts at $1.85. Actual cost to buy IMO should the put be assigned is $42.15 ($44 strike less $1.85 premium = $42.15) again about 10% below the current price.

The term “cash secured” implies that you hold sufficient cash or cash equivalents (i.e. money market fund, treasury bills, etc.) to buy the shares if they are put to you. With SU you would set aside $2,995 of your own capital plus the $205 premium from the sale of the put to secure your obligation to buy 100 shares at the $32 per strike price. In this way you are keeping cash on the sidelines to buy into the market on a pullback.

The advantage is that you are being paid to wait. If wither stock remains where it is (note it is currently above the strike price of the put) or rises the puts will expire worthless. In that sense you get to keep the premium received which is your reward for dipping a toe into the water.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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