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To buy or not to buy — your options on Canadian banks

In a roller coaster of a financial market, there may be a way to get more bank for your buck from Canada’s big five, says this analyst.

If you’re a Canadian without an investment in a big Canadian bank, you’re in a very tiny minority.

Whether in common stocks, preferred stocks, mutual funds or pension plans, there is at least one bank in almost every Canadian portfolio.

And despite the fact that they’re down, Canada’s banks still stand fairly tall against the flattened financial institutions elsewhere in the world.

Plus they keep paying their dividends.

Still, nothing seems very stable or predictable these days. Is it smarter to sell the banks now, or to buy more? If you don’t have any bank shares, should you get in now?

The best answer may be yes and no. Writing in The MoneyLetter, Mr. Ken McCord explains that a simple buy or sell decision may actually limit an investor’s opportunities.

There are more profitable ways to invest in the banks right now, says the author, a working CEO at Webb Asset Management. He proposes some intriguing alternatives — exchange-traded funds and options.

These may seem like exotic ways to buy the good old Canadian banks, but in this expert’s opinion, they can work for just about any investor.

Add a little sizzle

Mr. McCord begins with a frank admission. It is simply not possible to predict what the banks (or any other stocks) are going to do in the immediate future.

Rather than try to guess, investors should adopt different strategies. And those strategies should vary depending on whether you are bold, cautious, or somewhere in between.

This analyst begins with the “raging bull.” This assertive investor sees the banks with high dividend yields, capital ratios that are the best in the developed world, positive earnings (a rarity!) and attractive valuations.

So this investor would typically buy, hold and “earn a nice little dividend while the stock roars back to old highs.” That’s fine and dandy, says Mr. McCord, but why not add a little sizzle?

This comes in the form of leverage and it can be added with the Horizons BetaPro Financials Bull+ ETF (TSX-HFU). This exchange-traded fund offers double exposure to the stocks on the S&P/TSX Capped Financials index.

If the index goes up two per cent any given day, the ETF goes up four cent. Of course losses are doubled, too. But you have your investment nicely spread across a group of stocks as well.

There’s another bullish option — and it is literally an option.

For raging bulls only

A naked call option is for raging bulls only. This entails selling a call, or buy, option on the open market, without owning the security. You sell the right to buy shares at a fixed price. If the shares are below that price at expiry, the option won’t be exercised and you collect the premium.

In today’s volatile market, option premiums are expensive, says Mr. McCord. He suggests buying calls well out of the money (that is, above the market price), which will keep your costs down.

“This, of course, will increase the risk that the option expires worthless, but the payoff relative to the premium can be quite significant,” he adds. If you are a cautious investor, you are advised not to attempt this at home.

For those who are bullish, but not that bullish, there is an option strategy that is a little less of a high-wire act.

Enjoying the upside

The more cautious bull may wish to buy insurance on bank stocks (but not from AIG!). It’s done with a put, or sell, option. And it would solve the dilemma of those wondering whether to buy the banks now or wait.

“Buy bank shares now and use some of the dividend payments to buy a put option,” explains Mr. McCord. “This strategy will protect your downside and leave your upside intact.”

He uses TD Bank (TSX-TD), and for the sake of simplicity we’ll stick to his examples with their pre-rally share prices.

You would buy TD at $36, and buy a July $28 put option for $2. If TD goes up, your option expires worthless, but you enjoy the upside from the rising share price. If TD goes below $28, you put your stock to the market at $28, thereby saving further losses.

Premiums can be expensive these days, the analyst reiterates, but the high-yielding dividends on banks stocks can cover much of the cost.

There is even a way for conservative investors to get in on the option game, believe it or not. It involves selling volatility and collecting cash.

Selling away volatility

Here’s how income investors can turn the volatility in the market to their advantage (again using Mr. McCord’s original figures). You buy the stock and write an out-of-the-money call option.

Buy TD at $36. Owning it entitles you to a 6.5 per cent, or $2.44 annual dividend. Then you sell a call option, providing the right to buy your TD stock at a strike price 10 to 20 per cent above the current market price (or “out of the money”).

In this example, a call that is 20 per cent out of the money would give you a strike price of $42. A July call at that price would earn you about $1.80 over five months, or about one per cent per month. Add the dividend yield and you would earn about 18.5 per cent in income over a full year.

And that assumes the stock stays at the same price. If it rises to your strike price and you have to deliver, you still get five months of dividends and the call premium plus the gain in the share price.

If the stock goes down, you have a cushion in the call premium.

“Sure you may not get the upside above $42,” Mr. McCord concludes, “but selling away the volatility in exchange for income was the strategy. The outcome meets that objective quite nicely. ”

Of course, the recent rally has pushed the price above the numbers used in this article in The MoneyLetter — but it certainly hasn’t taken the volatility out of the market.

It goes without saying that options require careful study and sound professional advice. But in a risky market they can actually help cut your risk, in this analyst’s opinion. There’s more than one way to get money from a bank.