Playing Defence with Cash Secured Puts?

I have a love hate relationship with Canadian financial institutions. Canadian banks are tough competition for someone in the money management business. As an investment however, they are well capitalized – more than can be said for many European banks – and pay healthy dividends, which are bumped up on a regular basis. Or and did I mention, the big six Canadian banks are “too big to fail!”

Canadian insurance companies are also interesting although their performance has lagged the banking sector in recent years. Canadian insurers are mature beasts with virtually zero domestic growth prospects. A fact that has existed in the marketplace for years. The only domestic strategy for Canadian insures is to capture market share from competitors. Basically a zero sum game!

If that were not enough try pricing insurance contracts in an ultra-low interest rate environment. Not to mention annuities and casualty insurance where short term interest rates have remained near zero.

In the search for growth the largest insurance companies are looking beyond Canada. Manulife for example, continues to make inroads into Asia, particularly Singapore, China and Viet Nam. But given the size of Manulife analysts doubt it will have any serious near term impact on the bottom line. Certainly not the kind of market moving impact growth investors want.

The real impact for banks and insurers will come from higher interest rates. Banks because it will have a marked impact on their margins and insurance companies because they can earn a better return on their invested capital.

In the interim traders should look to this sector as a haven for low volatility blue chip stocks that pay healthy dividends. And while this may not be exciting, in the current environment it is an excellent defensive sector for your portfolio.

In the case of National Bank (TMX: NA, Friday’s close $42.0, dividend yield 5.139%) and Manulife (PMX: MFC, $17.90, 4.134%) traders might want to look at a writing cash-secured puts.

Since options take into account the spread between the risk free interest rate and dividends paid by the underlying company, the at-the-money puts on both NA and MFC are trading at much higher premiums that the same strike calls.

Traders who like the yield on National Bank might look at writing the NA October 42 puts at $2.50 per share. Set aside $39.50 out of pocket plus the $2.50 premium as capital to buy the shares should the short put get assigned. Assuming NA closes above $42 per share in October, your five month return on invested capital is 6.32%. If the shares fall, you will have to buy in at $42 less the $2.50 premium for a net cost of $39.50 per share. At $39.50 net cost the stock yields 5.47% which means, you might think about taking the shares and collecting the dividend.

With MFC, look at writing the January 18 puts at $1.60 per share. Set aside $16.40 out of pocket plus the $1.60 premium as capital to buy the shares should the short put get assigned.

Assuming MFC closes above $18 per share in January, your eight month return on invested capital is 9.75%. If the shares fall, you will have to buy in at $18 less the $1.60 premium for a net cost of $16.40 per share.