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The Conundrum: Strategy Selection!

Richard Croft
October 31, 2011
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6 minutes read
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Back in our September 26th blog (Copper Oversold?) we discussed the outlook for copper. Our view at the time was that copper was oversold and that negative sentiment had taken mining stocks down.

At the time, I suggested buying a couple of the junior down and out copper stocks (Copper Mountain Mining Corp. (TSX: Copper Mountain; Oct. 28 close: $5.42) and Quadra FNX Mining Corp. (TSX: Quadra; Oct. 28 close: $12.00) with the intent of writing covered calls against the shares. I also proposed writing cash secured puts to illicit the same potential return should the shares remain the same or rise. Both strategies provided limited downside protection.

These plays have worked well. In fact, the downside protection afforded by the covered call probably helped investors stay the course as the stocks sold off through the first week of October. Copper Mountain has advanced 15% since our Sept 26th article. Similarly, Quadra has rallied 28%.

The covered call strategies were profitable although less then the outright stock positions. You may recall that we suggested buying Copper Mountain at $4.71 and writing the January 5 call at 70 cents. The net cost to establish the Copper Mountain covered call was $4.01 ($4.71 purchase price less 70 cents premium = $4.01).

Now fast forward to Friday’s close and with the stock at $5.42, the January 5 calls were trading at $1.00. To unwind this position today, you would sell the shares and re-purchase the calls leaving you with a net credit of $4.42 per share. Now divided the net credit ($4.42) by the net cost to establish the position ($4.01) minus 1, and your return is 10.2% in a little over a month, versus 15% for the investor who was simply long Copper Mountain over the last month.

If we run the same numbers for Quadra using prices from the September 26th blog and fast forwarding to Friday’s close, the one month return from the covered call strategy is 12.2% versus 28% for the investor who did not write covered calls.

For the record I would take profits on the Sept 26th covered call strategies. Same for those who used cash secured puts to take the position.

That said, there is a broader question that needs to be asked. If you engaged in this strategy, how do you feel about your one month return? Are you happy that you earned 10.2% and 12.2% respectively? Or disappointed that your return is less then what you might have made having never engaged in the covered call?

There is no right answer. But how you answer is instructive in terms of quantifying your investment personality. If you appreciate the positives of the Copper Mountain / Quadra covered call experience, then you are probably a more conservative investor. You may be seeking cash flow, certainly want downside protection and prefer well defined entry and exit points. Those are more important considerations than upside potential. If that defines your experience, then you might think about integrating covered calls as a core strategy within your portfolio.

If your Copper Mountain / Quadra experience left you disappointed, then you are a more aggressive investor who wants to wring the most out of a position before exiting. Cash flow is not important, and downside protection is best served with “stops” or through long only call positions.

One’s investment personality – i.e. objectives and risk tolerance – should drive decisions on which strategies to implement when presented with ideas in this space. Notice that when I talk about particular stocks or sectors, I will typically point investors to a particular option strategy based on a directional bias and pricing metrics.

For example, the September 26th column was bullish on the outlook for copper and these miners in particular. Writing covered calls and / or selling cash secured puts are equivalent bullish strategies. Call buying is also a bullish strategy.

The covered calls / cash secured puts were suggested because the Copper Mountain and Quadra options were trading at above average implied volatilities. Which means in terms of their cost, these options were in the top quartile of all equity options in Canada. From a dollars and cents perspective, it made more sense to collect the premium then to pay up for a long call position.

Certainly for our aforementioned conservative profile that is almost always the right choice. However, for the more aggressive investor the covered call / cash secured put trade may never be the right choice. No matter the cost!

What we are saying is that any idea presented in this space is your starting point. The option strategy you choose to employ should be driven by your personal objectives and ability to tolerate risk. If you are an aggressive investor confronted with a bullish scenario, then by all means, buy the calls!

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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