Have the shares of Canadian financial services companies bottomed out?

Although the shares of Canadian financial services companies have taken a hit, we know — or, at least, we are being told — that these firms have weathered the credit crisis in better shape than most global financial services institutions. In fact, the U.S. government has even asked Canadian banks to consider taking over some of the ailing U.S. financial services institutions.

There are exceptions, of course. CIBC took significant capital hits in its fourth quarter ended Oct. 31, 2007, and its first quarter of fiscal 2008 as part of its deleveraging program. And, more recently, Toronto-based Manulife Financial Corp. sought and received $3 billion in loans from Canadian banks to shore up its capital base.

Manulife is interesting because it appears to be in the early stages of deleveraging. It could require further cash infusions to shore up its capital base. But even though insurance companies do not always enjoy the same access to capital that major banks do, Manulife is not expected to follow the dark path that New York-based American International Group Inc. was forced to walk. That said, Manulife will experience some major bumps in the weeks ahead.

So, for options traders, there appears to be some interesting opportunities within the financial services sector. That said, you must bear in mind that the enhanced volatility that has gripped the entire market has left options premiums in the financial services sector at record highs.

For example, options on Bank of Nova Scotia, whose share price was recently $37, are trading at 65% implied volatility. The bank’s exposure to Latin America has been a hot potato for investors. The fear is that while Latin America may be behind in the credit crisis, it will certainly not be immune to it. The real risk is the lack of credible information as to the extent of bad loans in the region and, more important, uncertainty as to how Latin American governments will manage the crisis. (Case in point: Argentina announced in late October that it is nationalizing private pensions.)

Having said that, Scotiabank has a healthy balance sheet and its annual dividend of $2.02 a share seems to be intact. At current rates, that dividend provides a yield of 5.45%. For the record, no Canadian bank has yet to suggest that its dividend is at risk.

With Scotiabank, one might consider writing January 36 puts at $3 a share. If the shares are put to you, your net cost is $33 (the $36 strike price minus the $3 premium), which would give you a yield of 6.1%, assuming the dividend remains in place.

You can find similar positions with other Canadian banks. For example, with Bank of Montreal — whose share price was recently $38, with a dividend yield of 7.34% and implied volatility of 65% — you could write the January 38 puts at $3.30. The net cost, if the shares are put to you, is $34.70 ($38 strike minus the $3.30 premium). At $34.70 a share, BMO’s dividend yield is more than 8%.

Royal Bank of Canada — whose shares were recently priced at $43.18 a share, with a dividend yield of 4.61% and an implied volatility of 60% — has January 42 puts trading at $3.65. If you write these puts, the net cost, should the shares be put to you, is $38.35 (the $42 strike price minus the $3.65 premium).

CIBC — whose share price was recently around $50, with a dividend yield of 6.95% and an implied volatility of 70% — is another example, although it is the one bank that may have an issue with its dividend. Still, the January 48 puts were trading at $4.50, which means that writing these puts would provide you with a decent premium. The net cost, if the shares are put to you, is $43.50 (the $48 strike price minus the $4.50 premium).

For your more aggressive clients, you could suggest buying calls on the iShares CDN financial sector index fund, which recently traded at $17.45 and had an implied volatility of 47%. Note the lower implied volatility assumption, which is the result of the diversification effect from holding a basket of financial services stocks.

@page_break@On the other hand, this basket includes companies such as Manulife, which has a significant weighting within the index. This could hold back the performance of the index if Manulife really is in the early stages of deleveraging.

But if you are dealing with a more aggressive trader and believe that, in general, the Canadian financial services sector has bottomed out, that it is deeply oversold and that it is poised for a dramatic rally, you could buy the iShares index fund January 18 calls for 75¢. IE