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Hedging Canadian Bank Risk with Debit Spreads

Patrick Ceresna
August 1, 2017
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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 31st, 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.

Patrick Ceresna
Patrick Ceresna http://www.bigpicturetrading.com

Derivatives Market Specialist

Big Picture Trading Inc.

Patrick Ceresna is the founder and Chief Derivative Market Strategist at Big Picture Trading. Patrick is a Chartered Market Technician, Derivative Market Specialist and Canadian Investment Manager by designation. In addition to his roll at Big Picture Trading, Patrick is an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada about the many valuable uses of options in their investment portfolios. Patrick is also co-host to the MacroVoices weekly podcasts. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities. With his specialization in technical analysis, he bridges important macro themes with the attempt to understand when those trends are beginning and understanding where they likely to go. With his expertise in options trading, he seeks to create opportunities that leverage returns, while managing/defining risk and or generating consistent enhanced income. Patrick has designed and teaches Big Picture Trading's Technical, Options and Macro Masters Programs while providing the content for the members in regards to daily live market analytic webinars, alert services and model portfolios.

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