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The Canadian Bear Market Roars!

Patrick Ceresna
February 4, 2016
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The Canadian Bear Market Roars!

I find a sense of irony that investors need to be losing 20% or more on their equity investments before the economic experts feel they can officially conclude that it is a bear market. It makes it almost meaningless to react to the news as often the worst part of the portfolio damage has already occurred. None the less, we find ourselves in a situation that is a double whammy for Canadian investors, as they are being pummeled by the currency and the stock market simultaneously. This makes the situation here financially far worse than places like Japan where their 2013-14 currency plight was accompanied by an equity rally, lessening the financial impact on the average Japanese investor.

TSX60

The brutal reality is that over the last 18 months, any Canadian investor invested in Canadian Dollars owning a Canadian equity fund is down over 20% on their investment and down a further 30% in the decline in the purchasing value of the currency. A hard pill to swallow!

Bear Market Options for Clients

The most common response given to clients is the typical cliché of “don’t panic”, focus on the “long-term plan”. While I fully understand that based on portfolio management theory, a diversified portfolio should be able to weather the storm; the increasing problem is that asset classes that in normal conditions behave uncorrelated suddenly correlate when volatility and fear are introduced to the market.

This is where I feel there is value applying a hedging strategy to reduce an investor’s exposure.

Implementing a Collar to Hedge Risk

While this strategy can be implemented on broader ETFs, we will illustrate the strategy on an individual stock. Let’s discuss a scenario where an investor has owned the shares of Alimentation Couche-Tard. The investor purchased 1000 shares of the convenience store operator back in 2014 at $30.00 a share and has been happy about the rise in the stock price to its current $60.24 level. The investor is torn as to how to proceed.

  • The investor likes the stock but is concerned that the stock may reverse lower and fall victim to the broader bear market.
  • The key consideration is that if they sell the shares, they will incur over $30,000 in capital gains.

The investor decides to implement an options strategy called a “collar” to protect their investment. This involves selling a covered call on the stock above and using the proceeds toward buying a protective put to hedge the downside risk. Here is the scenario:

  • Alimentation Couche-Tard (ATD.B) is trading at $60.24 (February 2, 2016)
  • The May $66.00 covered call is bidding $1.20
  • The May $58.00 put option is asking $2.50

The investor sells 10 of the May $66.00 covered calls (1000 shares) and receives $1,200.00 in premium income. At the same time, the investor buys 10 of the May $58.00 put options (1000 shares) for $2,500.00. This was at a net cost of $1,300.00 ($2,500.00-$1,200.00).

What has the investor created?

The investor has created a scenario where between now and the May 20th expiration, they have the obligation to have to potentially sell the shares at $66.00, or about 10% higher than where it is trading. At the same time, the investor has guaranteed that if the stock was to decline, they are able to sell it at $58.00, no matter how low it goes. During this time, the investor has 4 months to see how the stock behaves before making that critical decision to realize the tax liability of selling. At least in my eyes, this represents a solid alternative to the rushed decision to sell or hold.

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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