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Canadian Banks Topping Today’s Most Active

Jason Ayres
December 10, 2013
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After demonstrating how to take a confident stance on Toronto Dominion Bank using a protective put in last weeks blog titled Repositioning Using Puts , we see that a number of Canadian banks are starting the week off strong, occupying 6 of the 10 spots on today’s Most Active Options list:

most active December 9 2013

If an investor had a specific expectation or preference to any one the banks highlighted above, the solution would be to take a position by purchasing the shares, using an option strategy or a combination of the two. However, if the outlook was not specific to a particular bank, but more based on a bullish outlook for the entire Canadian banking sector an exchange Traded Fund (ETF) could be selected to meet the investors objectives.

As a reminder, an ETF is a financial security that can be bought and sold on an exchange like common publicly traded shares. The difference is the share or unit value reflects the net asset value of a portfolio of stocks much like a typical mutual fund. The main difference is that the ETF offers the investor the ability to buy and sell at their discretion throughout the day while benefiting from the diversification of holdings. One other major consideration is that many ETF’s are options eligible. For a full list of all of the currently available options eligible Canadian ETF’s CLICK HERE.

The BMO S&P/TSX Equal Weight Banks Index ETF – symbol (TMX:ZEB) is an ETF comprised of Canadian banks. As of December 6th, 2013 the top holdings were as follows:

ZEB top holdings

For more information on this ETF, please visit the BMO S&P/TSX Equal Banks Index ETF spec sheet.

As you will notice, all of the banks on today’s most active list are included in the composition of the ZEB. For the investor who would like exposure to this sector, but does not want to pick and choose between stocks, this is an ideal solution. The benefit is that any significant negative price action due to the unique circumstances of an individual bank is mitigated because it is averaged into the basket of stocks. The obvious draw back is that if one particular banking stock is outperforming, this is also mitigated by the average. Regardless, if “the tide comes in, and all ships rise” in the banking sector, the investor should participate in an appreciation of ZEB shares

There are a number of ways to participate in the longer term appreciation of ZEB shares.

  • Buy the shares outright (unlimited profit, unidentified risk)
  • Buy the shares and add a protective put (unlimited profit, identifiable risk but increased break even)
  • Covered Call (limited profit, unidentifiable risk, benefit of cash flow)
  • Buy the shares and collar them (limited profit, identifiable risk)
  • Long term option (limited risk, unlimited profit)
  • Longer term call Debit Spread (reduced cost, limited risk, limited profit)
  • Longer term Calender Spread (ongoing reduction in cost, limited risk, limited profit but the ability to adjust as shares appreciate)
These are just a few examples, however, for the sake of today’s posting, I want to focus on the merits of considering a longer term Calendar Spread.
A Calender Spread can be constructed in a variety of ways, but in general involve the use of options with differing expirations dates. In some cases it used to take advantage of price discrepancies between options with the same strike price but differing expiration dates. For more insight on this approach check out the following video found at www.m-x.tv http://m-x.tv/media/calendar-spreads.
For the purposes of this example, we will be using the Calendar Spread to meet an objective similar to that of a Covered Call Writer.
For example, with the TMX:ZEB currently trading at $21.00. An investor seeking to benefit from a longer term up trend might consider the following:
  • Purchase a June 2014, 20 strike call
  • Current asking price $1.45
  • Delta = .75 (option will appreciate $0.75 for ever $1.00 the stock increases currently)
  • Intrinsic Value = $1.00 ( Stock price – strike)
  • Time Value = $0.45 (premium – intrinsic)
  • Break even = $21.45 (strike plus premium)
The maximum risk between now and the third Friday of June, 2014 is $1.45/share. However, we could consider selling shorter term, out-of the-money call options as way to reduce the cost and lower the break even point. Let’s assume we could collect $0.05/share for writing the January 23 strike call. This would reduce our cost down to $1.40 and allow us to profit up to $23.00 between now and the third Friday of January. If we are assigned to deliver the shares at $23.00, we have the right to buy them at $20.00. As a result our profit would be $3.00-$1.40 = $1.60/share. This would not be a bad return by any means. However, if the shares are approaching $23.00 but close below the strike, the written call expires, we keep $0.05/share and have no further obligation to deliver.
We can then turn around and sell the following month expiration at a higher strike, collecting perhaps another $0.05/share or whatever the market is yielding at that point.
By doing this, we have further reduced our cost, and now benefit, from an even higher move in the shares comparative to the month before. In an ideal scenario, we can continue to do this month over month until we reach expiration or are assigned on the written call. Considering that there are 5 months until the June expiration, if the investor could collect an average of $0.05/month, this would reduce the cost of the longer term option from $1.45 to 1.20 or 17%.
The result is that the investor maintains an attractive risk reward balance while reducing the cost and break even point. If the shares rally between now and expiration and the investor is assigned, a profit is still realized. If the stock stays the same or drops a little, the investor is reducing their cost and break even with no added risk.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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