Should you Sell your Canadian Banks?

Yesterday I had one of our lifetime members of Learn to Trade Global walk into my office with a printed article from the Globe and Mail discussing the Moody’s downgrade on Canadian Banks. He was very concerned and asked me a good question, should he sell his large position in Scotiabank? In particular, he was concerned about the agencies reasons for the downgrade, sighting that “the banks are more vulnerable to unpredictable downside risks facing the Canadian economy than in the past because of the state of the housing market.” To read the article, click the link. http://www.theglobeandmail.com/globe-investor/moodys-knocks-canadian-banks-down-a-notch/article7910438/

As always, I immediately point out that Moody’s is not a market timing service, but rather a rating agency and that the downgrade does not immediately equate to a call to action to liquidate his investments. But as always, it was worth evaluating the risk/reward proposition of Scotiabank and all Canadian banks at this juncture.

This member originally bought a substantial stake of Scotiabank (TSX: BNS) at around $51.00 in the summer of 2012. At the time of this writing, the stock was trading at $58.81 or about 15% higher. The member originally bought the shares because Scotiabank was blue chip and paid an attractive quarterly dividend of $0.57. So selling it just because of a downgrade does not appeal to the bigger picture reasons why he owned it in the first place.

Considerations:

• Scotia Bank is near 52 week highs at $59.20.
• Scotia Bank is just 4% away from its all time high of $61.28.
• The investor is profitable by $7.81 of guaranteed profit if he sold it today.
• The stock has a key low in 2011 at $47.54.

So what could he 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 he did sell it, what would he buy? Should he sit in cash? How would he 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 he 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 he owns 1000 shares at an average cost of $51.00.

• Buy 10 July $54.00 puts for $0.70 or a $700.00 cost.
• Sell 10 July $62.00 covered calls for $0.35 or a $350.00 income.
• This strategy will cost the investor $350.00 in total net cost.

What is the outcome for the next 6 months?

• The investor is likely to receive the next two dividends for $1148.00 in income.
• If the covered call option is exercised at $62.00, the investor is being forced to sell it at all-time new highs and an $11.00 or $11,000.00 capital gain.
• If the “unpredictable risk” occurs and the stock drops toward its multi-year lows around $47.50, the investor is guaranteed to be able to sell the stock at $54.00 by exercising the put option. This would still have a realized capital gain for $3,000.00 from his $51.00 original cost base.
• If the stock does nothing, the investor continues to collect dividends and can sleep at night knowing that he is 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

Patrick Ceresna, CMT DMS CIM
Chief Derivative Market Strategist
Learn to Trade Global