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Yola Edwards

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Charting a course through the turmoil

Yola Edwards

While media and investors alike were caught up in the excitement of the market’s new highs in February, technical analysis offered up some warning signals in January as technical indicators diverged negatively. Now, with the forewarned correction behind us, the swiftness of the retreat has spawned a perception that significant market volatility may become a common place occurrence. The question is, is that perception correct?

Although the markets rallied for a few days after the initial sell off in early March, leaving investors feeling a little comforted, the second shoe had to drop. How then can you defend yourself against future volatility? The answer lies in your view of the level of anticipated future market volatility.

Utilizing options to manage risk and volatility may be a management tool worth consideration. Options are often employed as a hedge and the chart below offers a brief option strategy guide to meet investors’ corresponding volatility assumptions.

OPTION STRATEGIES
STRATEGYINVESTOR’S ASSUMPTIONFUNCTIONMAXIMUM RISKMAXIMUM REWARDBREAKEVEN PRICE
NEUTRAL OPTION STRATEGIES
Short Straddle: Simultaneously sell call options and put options on the same stock with the same strike price and the same expiration date. (Use at-the-money (ATM) options, for best results)Very low volatility: Expect stock to stay at or close to strike price. Investor is neutral.Very high risk strategy: For investors who want the high premium receivedUnlimitedNet premiums receivedCall strike price + net premiums received; Put strike price - net premiums received
Short Strangle: Simultaneously sell call option and sell put option with different strike prices on the same stock and expiry. Strike price of call usually higher than put.Low volatility: Expect stock to stay between the two strike prices.Very high risk strategy: For investors who want the high premium receivedUnlimitedNet premiums received if call strike > put strike price. If call strike < put strike = Net premium - (put strike - call strike)Call strike price + net premiums received; Put strike price - net premiums received
Long Straddle: Simultaneously buy a call option and buy a put option on the same stock with the same strike price and same expiry date. (Use ATM options)High volatility investors: Expect a very sharp price movement, but unsure of the directionInvestors expect a very sharp price movement, but are unsure of the directionNet premiums paidUnlimitedCall strike price + net premiums paid; Put strike price - net premiums paid
Long Strangle: Simultaneously buying a call option and a put option on the same stock with the same expiry but different strike prices.Very high volatilityInvestors expect a very sharp price movement, but are unsure of the directionIf call > put premiums paid; If call < put premiums paid - (put strike price - call strike)UnlimitedCall strike price + net premiums paid; Put strike price - net premiums paid
Calendar Spread: Simultaneously buying or selling an equal number of puts or calls on same stock with same strike price but different expiry dates. Long side should expire at the same time or after the short side. (Use ATM options)Neutral market declining volatilityInvestors expect sideways price move. Could be used to generate incomeNet premiums paidLong option strike - net premium paid. Alternatively, if short expires, call spread = unlimited reward. Put spread = strike price - net debitWill constantly drift
Collar: Own stock, sell a long-term call or LEAP and buy a LEAP with the same expiration month but different strike prices. (Use an out-of-the-money (OTM) options)Any volatilityNeutralize positionNo risk tradeLong option strike price - net premiumStock price - net premium received

Contrary to popular belief that options are risky investments, options were actually created to reduce risk. You’re probably surprised to hear that since you may have heard that 90 per cent of options expire worthless. In fact, only 30 per cent of options expire worthless in each month’s cycle; 10 per cent are exercised and 60 per cent are traded out before expiry.

In light of the recent market retracement, the word "volatility" may convey a negative impression. But, "what goes down must go up," as the saying goes. A technical look at the market now indicates a positive outlook as both the Dow and the TSX appear to be extremely oversold.

It appears that a bottom, for the time being, is at hand with respect to the TSX. The March 5 trading session ended with a low registering at 12,674 and resulted in an inverted hammer bottom candlestick pattern while the following day’s session traced out a regular hammer bottom candlestick pattern signalling a decisive reversal.

The lows were subsequently retested when, on March 14, the TSX plunged 148 points slightly exceeding the previous week’s lows, posting a new weekly low at 12,661. But, the same day, it turned on a dime, managing to roar back and close even on the day at 12808 suggesting the lows have been seen for now. Furthermore, the oversold MACD appears to be turning positive, although it hasn’t given a clear buy signal, and it has diverged positively helping shape a bottom. While the immediate direction looks promising there could be more zigging and zagging. The longer-term picture suggests that over the next year the market should continue to rally higher as several bullish patterns from April-Dec., 2006, offer a solid base. The index has achieved the first target of 13,004 provided by the smaller inverted head and shoulders pattern from May to Aug. and the next bullish pattern, outlined by the ascending triangle, suggests a target of 13,550, coinciding with the upper Bollinger band. The third pattern is a larger inverted head and shoulder pattern with a potential target of 14,196 likely to be achieved by Nov., 2007.

The longer-term picture continues to favour bullish markets as the weekly charts (not shown) suggest a potential 3-year target of about 21,888, based on an Elliott wave count. With those parameters in mind, coupled with your own perception of the market, you should have ample strategies to choose from.

Yola Edwards is a contributing writer and technical analyst for Bell Globemedia Interactive, providing options and technical analysis research on a variety of North American equities.

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