Locking in Profits on the Canadian Banks

“October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February

– Mark Twain

Here we are in the first week of October and my phone is ringing off the hook with concerned investors asking if they should be worried about their investments with the political gong show going on south of the border. I pride myself on trying to create alpha by market timing the bigger stock market cycles and certainly the technical evidence is suggesting that the market is at the tail end of at least an intermediate advance. While this does not mean a bear market is imminent, we do certainly believe that the market represents a diminishing risk/reward proposition for seeking additional gains.

In the Canadian market, the Canadian banks have been particularly impressive with their advance over the last three months. While the majority of bank stocks have done well, we will look at the price advance of Bank of Montreal to put into perspective the current conditions, and review an option strategy investors could consider to lock in gains.

The Bank of Montreal has had 4 significant bull advances over the last 4 years. Observe the table below. Notice that the average duration of the advances has been 100 days resulting in an average rise of $9.06 or 17.28%. The current rally is now 114 days in duration and resulting in a rise of $11.71 (19.96%). This does not guarantee that the stock will decline, nor does it suggest the stock cannot go higher on the short term, but it does suggest that there is a diminishing upside benefit for an increasing amount of risk.

From our perspective, this does not mean that investors need to sell the shares of their high quality dividend paying stocks, but it is a time to consider the collar strategy to dynamically manage the risks at the current price levels.

Let’s assume that the investor originally bought a substantial stake in Bank of Montreal (TSX:BMO) at around $60.00 in the 4^th quarter of 2012. At the time of this writing, the stock was trading at $70.20. The investor originally bought the shares to own a blue chip stock with an attractive quarterly dividend of $0.74.

Considerations:

• Bank of Montreal is at its 52 week highs.
• The investor is profitable by $10.20 of guaranteed profit if they sold it today.
• The stock had a key low in 2013 at $58.02.

So what could the investor do now?

It is easy to just say sell it, but we don’t know if that is the best solution in the bigger picture. If the investor did sell it, what would they buy? Should they sit in cash? How would they replace the income the dividend was bringing in? Is it worth creating a significant tax disposition? While those questions could be debated, we wanted to discuss a strategy on what this investor could do if they decided to keep the shares.

The Collar Options Strategy

Let’s look at the idea of creating an options strategy referred to as the collar. If you are unfamiliar with the strategy, please watch this short MX video. http://www.m-x.tv/media/collar-strategy

For the illustration of the collar, we will assume this investor owns 1000 shares.

• Buy 10 January $68.00 puts for $1.20 or a $1,200.00 cost.
• Sell 10 January $72.00 covered calls for $0.55 or a $550.00 income.
• This strategy will cost the investor $650.00 in total net cost.

What is the outcome for the next 4 months?

• The investor will receive a dividend for $740.00 in income.
• If the covered call option is exercised at $72.00, the investor is being forced to sell it at all-time new highs and a $12.00 or $12,000.00 capital gain.
• If the “unpredictable risk” occurs and the stock drops toward its year low around $58.00, the investor is guaranteed to be able to sell the stock at $68.00 by exercising the put option. This would still have a realized capital gain for $8,000.00 from his $60.00 original cost base.
• If the stock does nothing, the investor continues to collect dividends and can sleep at night knowing that they are guaranteed to make money on the position.

I am certain that there are many different opinions on this approach, but I for one would be very happy with this proposition.