From all reports, it appears that oil prices are also firming. Mainly on the back of increasing demand supported by a global economic recovery. According to The Wall Street Journal, futures markets are pricing December 2010 natural gas contracts at $7.25 per million btu, implying an oil/gas price ratio of 10.8. Assuming of course, that oil prices remain stable.

If you buy into the upside potential of natural gas and if you like aggressive strategies, then you might look at buying longer term calls on Talisman Energy Inc. (TSX: TLM, recent price $16.40) or Canadian Natural Resources Ltd. (TSX: CNQ, $59.64).

If you like Talisman, then you might consider the TLM January (2011) 17 calls trading at $3.60. With Canadian Natural Resources, I would look at shorter term options, mainly because of the wide bid asked spread that exists with the 2011 contracts. You should be able to buy the CNQ January 60 calls (i.e. expiring in January 2010) at $8.00 per share or less.

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When determining the long-term merits of an option writing strategy, one has to have some view as to how often stocks, or stock indexes, make significant moves. If, for example, it were shown that stock prices frequently defy the mathematics of a lognormal distribution, then options writing would probably not measure up as a standard long-term strategy equivalent to “buy and hold.”

However, most studies conclude that, longer term, option writing generates a return similar to a buy-and-hold strategy, with less risk. In Canada, the Montréal Exchange’s Covered Call Writers Index (symbol MVX) and in the U.S., the CBOE Buy Write Index (symbol BXM), have both shown that a passive option writing strategy produces the same return associated with buy and hold, with about 70% of the associated risk. And the data goes back 16 years in Canada and
24 years in the US.

Of course whenever looking at history, one must be mindful that the past is not necessarily indicative of the future. But there is an academic basis for the numbers.

The academic community spends a lot of time talking about the efficiency of the financial markets. And while there are various camps as to just how efficient markets are, there is a reasonable position that states the following; the current price of a stock reflects the markets best assessment of value based on dissemination of all publicly available information.

The stock market allows you to take a position if your view on a stock’s potential differs from the view of the general public. You buy if you think the market is understating future potential, and sell if you think the market is overstating future potential. But, and this is key to the discussion, you invest in stocks for the potential based on direction.

Unlike the stock market, the options market does not pit buyers and sellers on the basis of potential, but rather, does so on the basis of risk. The premium paid or received from an option is the market’s best guess as to the risk inherent in the underlying security. This so-called implied volatility concept is simply the option market quantifying risk.

For example, consider the straddle as a strategy. If you buy or sell a straddle – i.e. you buy or sell a call and a put – you have entered a volatility trade, which is not directionally based. If you were to pay a total of $10 for the call and put on a $100 stock, you want the stock to move up or down by at least $10 per share. You are not concerned about direction, you are concerned about the extent of the move. It is this strategy that makes the option market unique, as there is no other market I am aware of, that allows one to enter non-directional trades.

If we accept that the option market is also efficient, then the strategy of writing covered calls or cash secured puts, brings together two efficient markets; one that prices potential (the underlying stock market) and another, that prices risk. Theoretically, if the markets are really efficient, option writing should produce better risk adjusted returns than a buy and hold on the underlying index. In which case, maybe past risk adjusted performance metrics will indeed be repeated.

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A number of great questions surfaced from the attendees. And I will make an effort to address some of these questions in future blogs.

One question that struck me over the weekend was related to the disparity between the volatility implied in the premium for in-the-money versus out-of-the-money options.

There are two components within an option premium; 1) time value and 2) intrinsic value. The latter being the in-the-money amount of the option. Time value being the options total premium less its intrinsic value. Volatility only impacts time premium.

To put some meat on this skeleton, let’s take a look at Suncor options. With the stock trading at $38.47 per share, the out-of-the-money Suncor June 40 calls are trading at $1.75 with an implied volatility of 44.36%. Note that the entire premium in the July 40 calls represents time premium and thus volatility has a significant impact on its price.

At the same time, the deep in-the-money Suncor June 24 calls are trading at $14.50 with $14.47 of intrinsic value and 3 cents of time value. The implied volatility is 78.50%.

On the surface, one might conclude that the Suncor June 24 calls were overvalued. But that conclusion assumes that deep in-the-money options actually trade like options. In reality, they don’t.

The deep in-the-money Suncor July 24 call will act more like a stock substitute, and will trade almost dollar for dollar with the underlying stock. Which means that the volatility assumption embedded in the contract has very little meaning.

In my opinion, you should ignore implied volatilities on deep in-the-money or deep out-of-the-money options. And pay particular attention to the implied volatility numbers on the close-to-the-money calls and puts.

These options have the most time value and act most like an option. As such, these volatility numbers are the best proxy as to the option markets’ best guess about future volatility in the underlying stock.

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Personally, I think the silver rally has more legs. Mainly because I think of silver as an industrial metal, like platinum and palladium. Which means this rally reflects rising demand in anticipation of an impending economic recovery. Not concerned over inflation at some point in the future.

Additionally, the increase in demand for silver is coming at a time when supplies are waning. Normally, supply demand imbalances lead to higher prices. But as we have learned all too well, the current economic climate is anything but normal.

If you buy into higher prices for silver, you should look at companies that will provide you with the best exposure. One that comes to mind is Pan American Silver Corp. (TMX: PAA, recent price $25.58).

Options on PAA trade on the MX, with expirations in June, July, September and December. Aggressive traders might look at buying July 25 calls at $2.20 per share (implied volatility 49%).

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Beyond that, the government has also made it clear there will be no fire sale of bank assets, no significant dilution to their balance sheets. And with capital ratios ramping up to “safe” levels, many banks are eager to repay those government bailout loans.

Obviously, this comes as a major relief to Canadian banks, most of which had considerable exposure to “troubled” US assets. And all, to one extent or another, were vulnerable to a US meltdown. Canadian financial sector stocks have rallied strongly since their March lows in tandem with the broader market advance.

The question is whether the advance will stall as the market enters a resistance zone. It is not likely we will set new highs without some real signs of growth. A slowing of the downward trend will no longer be enough to spur markets higher.

If you believe as I do, that a short-term retracement in the Canadian financials is likely – albeit temporary – then covered call writing is an ideal strategy. Table 1 looks at some potential covered calls on the Canadian banks.

Table 1 - Covered Call Writes

* Return if unchanged

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According to China Minmetals Nonferrous Metals Co., refined copper imports are expected to rise 34% in 2009, to 1.95 million tonnes. In the first quarter, China imported nearly 1 million tonnes.

Having said that, this appears to be nothing more than a replenishing of raw material inventories, likely financed by China’s economic stimulus package. What better way to spend government money than to stockpile for an eventual economic recovery.

Interestingly, China is one of the few world economies where government spending has delivered the attendant results. And we all know that government spending is only a stop gap measure. Any price re-alignment directly correlated to an unsustainable spending package will eventually fade away. Unless of course, the recovery takes hold, and demand begins to grow at the grass roots.

So far, China is the only big buyer on the board. If an expected seasonal downturn in demand blocks further copper imports, even temporarily, spot prices could slide quickly. And that could negatively impact share prices of Canadian base metals. And it could happen quickly.

If you are an aggressive trader, you might consider short-term puts on base metals stocks like HudBay Minerals (TSX: HBM, recent price $7.10) and Teck Resources (TSX: TCK.B, recent price $14.28). Specifically the HBM June 7 puts at 50 cents, or the TCK June 14 puts at $1.35 or less.

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GIF is more than ten years old, which means over the next 24 months, Manulife may have to come good on some of those early guarantees. Meaning a large portion of those segregated fund reserve requirements are real, and not just hypothetical exposure at some point in the future.

Clearly, the fourth quarter 2008 sell-off that extended into the first quarter of 2009, seriously impacted GIF capital requirements (which were subjected to mark to the market accounting rules) and Manulife profits. Last week, Manulife reported a first quarter loss of -$0.67 per share versus a $0.57 profit in the same quarter a year earlier.

The bottom line is that Manulife, more than any other financial institution, is linked and likely leveraged, to the stock market. And while the resurgent stock market has eased pressure on the capital requirements, the question is whether markets will continue to rally near term.

Certainly markets have responded to so-called green shoots indicating a slowdown in the rate of decline. But to go higher, I suspect investors will need to see real evidence of real growth.

Options on Manulife are trading at 43% implied volatility. High by historical standards, but less than half Manulifes’ peak volatility. If evidence of growth emerges in the fourth quarter, markets will react early in the third quarter. Manulife is one way to leverage that scenario, options are a way to leverage Manulife.

Take a look at the Manulife July 24 calls at $1.65.

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Since 1938 was, by all accounts, a very good year for stocks, the bulls have been big supporters of the conspiracy oops, comparison theory.

The comparison begins in 1937, a year in which the Dow Industrials fell 40%, from the August high of 190 (much like the highs set in August 2008) to a November low of 112 (similar to the November 20th 2008 bottom, precipitated by the collapse of Lehman Brothers).

Having established a near-term bottom in November 1937, the Dow quickly rallied to 130, and traded in a range (120 to 130) until March 1938. Again similar to the moves at the end of 2008 and into early 2009.

By March 1938, the market had become overbought and collapsed, taking the Dow down to 100 in March 1938. Similar to the lows recorded in February 2009.

The rally off the March 1938 lows took the market up 20%. In 2009, the market rallied more than 30% off the February lows. Just because the 2009 rally was bigger, it does nothing to discredit the comparisons. Writes Lawrence McMillan at www.optionstrategist.com, “those who claim similarity between the two years are not talking about matching exact moves, but rather the pattern of the trading.”

At this point, the US equity markets have experienced two weeks of consolidation following the 30% pop from the lows. It took more than two months of consolidation in 1938 for the market to work its way through an overbought condition resulting from a swift rally. Technical analysts are looking for a similar trend to unfold this year.

But the kicker for this comparison theory is yet to come. The real oomph from 1938 occurred from June to November, when the Dow surged an additional 21% to 158. Culminating in a 58% total return from the March lows to the November highs.

Translating that into 2009 numbers, and we could see the S&P 500 index (SPX) at 1068 by fall. That’s the comparable SPX value if we equate the closing low of 676 on SPX in March, 2009, with the low of Dow 100 in March, 1938. McMillan provides us with the other comparable Dow/SPX points as follows;

Initial rally after February/March 1938 lows Dow 120: SPX 811 (already passed this)
Initial peak in June 1938 at Dow 145: SPX 980
Final peak in November 1938 at Dow 158: SPX 1068

McMillan offers a note of caution for anyone intending to use 1937 - 1938 comparables as gospel. The 1938 rally did not kick start a bull market. Values for the Dow remained well below the pre-depression level of 380 level which occurred in 1929. “It [1938] was just a strong rally – part of a long bottoming process in the worst bear market ever.”

From an option traders perspective, two strategies come to mind. The first is a middle-of-the- road covered call strategy. Since you will be owning stock, you can remain invested through the summer, should the market rally as in summer of 1938. If the market treads water through the traditional lazy hazy days of summer, then the option premium will pay you to wait.

If you buy the 1938 scenario as gospel, then a long call position is the right approach. Pick your favorite index (XIU comes to mind) and buy at-the-money calls with a July expiration.

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• Groupe Aeroplan Inc. – AER
• ING Canada Inc. – IIC
• Horizons BetaPro NYMEX Crude Oil Bear Plus ETF – HOD
• Horizons BetaPro NYMEX Crude Oil Bull Plus ETF – HOU
• Horizons BetaPro S&P/TSX Capped Financials Bear Plus ETF – HFD
• Horizons BetaPro S&P/TSX Capped Financials Bull Plus ETF – HFU
• iShares CDN MSCI EAFE 100% Hedged to CAD Dollars Index Fund – XIN
• iShares CDN S&P 500 Hedged to CAD Dollars Index Fund – XSP

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http://www.optionsource.net/mediaplayercanadian.php

For more information on the XIU options, click on the link below:

http://www.m-x.ca/nego_cotes_en.php?symbol=XIU*&image.x=12&image.y=9

Regards,

Patrick Ceresna

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