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What About The Banks?

Jason Ayres
January 30, 2015
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8 minutes read
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Since my colleagues have already discussed Canadian Investors’ favorite topics, oil and gold (see Has Oil Bottomed? By Richard Croft and Is the Divergence in Gold and Opportunity? by Patrick Ceresna), I thought I would take a look at Canadian banks.

Canadian banks have no doubt come under pressure, dropping an average of 15% from the re-test of the 2014 highs, back in December, to their recent lows. Most of this can be attributed to investor concerns over the fall out from declining oil prices. Concerns have been based on an expected disruption in several lines of business. This includes a decline in underwriting revenues, derivatives risk exposure and possible default in uninsured mortgages, home equity lines of credit and credit card payments in the oil producing provinces.

To add to the pressure, the Bank of Canada lowered interest rates by 25 basis points last week. As a result, Canadian banks lowered their lending rates. The issue with this is that the banks rely on the spread between what they can borrow at versus what they can lend at. As key interest rates drop, the spread tightens and profits suffer. Interestingly enough, the 6 major banks only adjusted by 15 basis points in an effort to protect the already low lending margins. In addition, forecasts are pointing towards lower economic growth in 2015, which further adds “fuel to the fire”.

Investors have a habit of over compensating for the unknown. While there are still many unknown variables, it does appear as though bank share prices in general may be stabilizing at these current levels. Let’s take Toronto Dominion for example (TSE:TD). According to marketwatch.com, many analysts are rating TD as a buy and share prices appear to be finding some support at $50.00, which is a previously tested low. As a side note, the charts look considerably different on the NYSE due to the currency consideration. A factor that deserves significant attention as a Canadian investing in U.S. securities.

With TD earning due out on February 26th, we will see just what impact the lower oil prices and poor economic forecasts have had on the companies last quarter.

Many investors are motivated to own Canadian bank shares because of the stable dividend stream they provide. However, with uncertainty looming, using a call option as a stock replacement strategy offers the investor the right to own the shares at these depressed prices with a limited risk exposure. While the option buyer does not have the right to the dividend, it is important to note that dividends are already priced in to the value of the option. This actually reduces the cost of the contract from what it would be if the stock did not issue a dividend. In addition, the potential risk of holding the underlying shares may not initially be worth the 4% dividend yield.

With this in mind, we could look at purchasing a call option on Toronto Dominion (TSE:TD) ahead of the February earnings. In this example, I want to look at holding a longer term position in TD into 2016. This will allow me to benefit from any share appreciation over the year, but limit my risk exposure to a fixed amount during times of uncertainty. If the shares take off at any point and are trading above the strike price I have selected, I have the right to take possession of the stock.

With TD shares trading at $51, we could purchase a call option at the $52.50 strike price expiring in January 2016 for $2.99 per contract. This represents our maximum risk on the shares for almost an entire year. It is important to note that our break-even point is $55.50 per share. This means that on expiration, the shares must be trading above $55.50 for the position to be profitable. By using the option as a stock replacement strategy, we limit our risk on the shares to approximately 6%, when considering today’s prices. Compare this to an unidentified risk exposure for the out right share holder.

If, for example the shares finish the year at the previous high of $58.00, the option would have an intrinsic value of $5.50. This is determined by subtracting the strike price of the option ($52.50) from the settlement value of the stock ($58). This reflects a 84% return on risk.

For the income focused investor, outside of your registered accounts, you can implement the calendar spread strategy. While holding the longer term call option, you can sell out-of the-money calls to generate a monthly cash flow as you would in a covered call strategy.

For example, while holding the January 2016, $52.50 strike call, you could sell the February $54 strike call for $0.20. If you can collect this kind of premium on a regular basis, you will significantly lower the average cost of your longer term option and subsequently reduce your break even point on the shares.

The trade off with this approach is that if the shares jump beyond the written strike, you may be assigned to deliver them. In the example above, as the stock approached $54, the investor may be motivated to buy the written call back and roll the position by selling a call at a higher strike and further out expiration date.

If you are interested in owning TD at these levels, consider the longer term call option purchase as way to gain exposure with a limited and identifiable risk for almost an entire year. Of course if shares continue lower the option always be sold for a partial loss rather than holding out until expiration and risking the option expiring worthless.

Regardless of how you manage or modify the position, the longer term call option offers the investor the ability to take a decisive stance on a stock and weather some of the short term uncertainty with a limited and identifiable risk exposure.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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