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Help for financials may hold opportunities

Advertisement Implied volatility, as measured by the Chicago Board Options Exchange’s volatility index, a.k.a. the VIX, rocketed to 42 on Sept. 18. This five-year high marked the short-term bottom in the Standard & Poor’s 500 composite index. When the market rallied on Sept. 19, backed by the prospect of a government bailout, the VIX immediately declined to 32. So, why is this data important? To put it simply, the VIX is a tool that allows us to quantify the emotional response of investors to activity in the financial markets. Emotions provoked by market events run the gamut from fear to greed, and instantaneously show up on the VIX. Not that you can reasonably profit from an emotional roller coaster that careers up and down on an intraday basis. But, on a longer-term basis — which is to say, weekly or monthly — the VIX provides information that can be useful when establishing a forward-looking portfolio strategy. For example, since the middle of last year, when the credit crisis first surfaced, the VIX has remained consistently between 20 and 30, considerably higher than its average level of between 10 and 20 during the previous four years. Essentially, the VIX is telling us that the “fear” factor is alive and well — and likely to remain in force for the foreseeable future. This suggests that options-writing strategies are, on average, probably the best choice within a portfolio. Covered call writing is one approach — as is the corollary to that, writing cash-secured puts — particularly on commodities companies, including gold, energy and agricultural. Even the U.S. financial services sector might be included. Although its volatility remains especially high, there is now a likely floor to valuations, supported by none other than the “Warren Buffet” factor following his decision to take a large position in Goldman Sachs Group Inc. last month. In this context, covered calls on financials such as New York’s Goldman Sachs, Morgan Stanley & Co. Inc., Citigroup Inc., Bank of America and San Francisco’s Wells Fargo & Co. come to mind. Another strategy born of the bailout that probably has merit is Toronto-based BCE Inc. If you buy U.S. Treasury Secretary Henry Paulson’s argument that the bailout will allow banks to get back to the business of loaning money, then the BCE deal will be a classic case study. Being a creditworthy debt issuer, it certainly fits the model should the deal go through at $42.75 a share. As of late September, BCE was trading at less than $38 per share. As you would receive $42.75 on this deal if it goes through as planned in December, your return over the next three months, on the current price, is 12.5%. That a successful conclusion to this deal yields such a healthy return implies that many stock traders are sitting on the fence as to whether this deal will actually get done. The same cannot be said for the options market. I note, for example, that at the time of writing, the BCE December 42 calls were bid at 50¢. If this deal goes through as expected, the Dec 42 calls would be worth 75¢ at expiration. If the deal doesn’t go through, these calls expire worthless. Clearly, someone or some group in the options market believes the deal will go through as expected and are willing to pay up with a 50¢ bid to play the takeover game. If we flip our position from being a buyer of the BCE Dec 42 calls to being a seller, we begin to see the benefits of options writing. In this case, with the calls at 50¢ at the time of writing, you can buy BCE shares for less than $38 and sell the Dec 42 calls. The premium received from the sale of the call reduces your cost of buying the shares, and all you give up is the last 25¢ in the value of the takeout price. (You will receive $42 for your shares and you get to keep the 50¢ a share premium.) A classic case study in getting paid to hold risk. On a macro basis, options writing makes even more sense. You could argue that the bailout rally on Sept. 19 had more to do with covering shorts than with a real sea change in market sentiment. In other words, the financial markets in general are not likely to surge to new highs anytime soon. A genuine turnaround, in fact, seems unlikely until market participants begin to focus on fundamentals such as earnings, consumer spending patterns, the depth of the U.S. recession and the long-term impact the bailout will have on U.S. government deficits. 1 | 2 | NEXT PAGE >> Read other news from our Research Section