Hedging Canadian Bank Risk with Debit Spreads

The recent hawkish shift and rate hike by the Bank of Canada has ushered in a resounding 10% rise in the Canadian dollar in a few short months.  This has not only put stress broadly on Canadian equities, but it has instilled concerns about the tightening of credit conditions on an already over indebted Canadian consumer.  This particularly brings to light the growing concerns on the economic impact if the tigher monetary conditions were to start cooling off the red hot real estate markets.

A slow down in real estate and consumer spending may weigh heavily on the Canadian banking system which has been relatively strong over the last 18 months. For the average investor, the focus on longer-term investing while holding a relatively stable dividend stream, diminishes the desire to make short-term trading decisions and to focus on the bigger picture.

This is where hedging your bank stock position with an option overlay is an interesting proposition.  In this case, let’s look at TD Bank as a candidate for hedging the downside risks.

While on the surface it appears to be a simple exercise of buying a protective put, but there is some idiosyncrasy to the existing option chains that needs to be considered.   The most obvious is the significant skew in the implied volatility.  I would speculate that one of the precipitating factors in creating the lopsided skew (particularly the low implied in the $64-$72 range) is likely attributable to the increased popularity in premium selling strategies like covered calls.

With above average dividends being discounted into the pricing, there is a diminished attractiveness to implementing strategies like collars and outright protective put buying. So how does one consider a more prudent approach to hedging downside risk?

One strategy that naturally complements the lopsided skew are put debit spreads.  This is structurally because you are buying the lower IV (implied volatility) and selling the lower strike with a higher IV.  This often allows the spreads to be open with favorable risk/reward propositions. Let’s look at the current pricing of a downside hedge on TD Bank using a debit spread:

Here is the breakdown:

• TD Bank (TSX:TD) is trading at $64.30 (July 31^st, 2017)
• TD Bank has a 52wk range of $55.78 – $71.31
• The January $62.00 put option is trading is bid $1.80 – ask $2.00
• The January $56.00 put option is trading is bid $0.55 – ask $0.80
• The spread is bid/ask $1.00-$1.45 (reasonable to be filled at or under $1.40)
• TD is scheduled to pay $0.60 quarterly dividends in October and January

An investor that overlays the put debit spread over a long stock position has hedged the downside risk of TD Bank below $62.00 down to its 52-week lows near $56.00.  Assuming a fill price on the spread around $1.40, the investor will have a near neutral cash flow carry net of the dividend stream.   For those investors that are looking to hold their bank stocks long-term but wish to hedge out intermediate risks can consider this approach.