Richard Croft, president and chief investment officer at R. N. Croft Financial Group
Focus: Options and ETFs

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MARKET OUTLOOK

APPLYING CHAOS THEORY TO FINANCIAL MARKETS

President Trump likes chaos, financial markets don’t. This is something that became abundantly clear for Amazon shareholders and equity markets in general during the last week of March. The trick is to focus on the long term while dodging bullets hurled in a reckless Twitter feed. To do that, we need to have a rudimentary understanding about what makes Trump tick.

On the surface, it appears that we’re dealing with a man who has a narcissistic personality disorder and is quite willing to engage in self-indulgent payback, even if it means slamming mega-companies like Amazon. In this case, the payback is aimed at Jeff Bezos, the online giant’s billionaire president who just happens to own the Washington Post, an outlet which editorially has been one of the harshest critics of the Trump administration. 

But Trump’s mastery of the “get-even” psyche only scratches the surface and it may not be all bad because after all, Trump isn’t a politician. His outside voice has no filter and aligns perfectly with his inside voice. That’s unique because most politicians’ outside voices have never even had a first date with their inside voices.

We also know that Trump’s approach to negotiating is based on a stick-and-carrot approach. We’ve witnessed this “throw-a-hand-grenade-into-a-room-and-walk-away” strategy play out in the NAFTA negotiations, the U.S. refusal to endorse the Trans Pacific Partnership (TPP), clashes with NATO about cost-sharing arrangements and more recently, getting North Korea to bend under the weight of sanctions.

The steel tariffs were the most recent volley in this chaotic approach to negotiating. The notion of tariffs was enough to send shivers through financial markets fearing an all-out trade war. But that was never the likely outcome because there is a vast chasm between Trump bluster and economic reality.

Steel and aluminum tariffs were interesting because they were clearly a political move from which there was no chance that an all-out trade war would ensue. America’s trading partners quickly provided a list of duties on products that were of little importance to the trading partners, but that were directed squarely at states that are Trump’s base.

Trump gains nothing from a trade war, especially if the other side targets his base. Notice that I said Trump, not the U.S. Make no mistake: everything we have witnessed is about Trump — it has little to do with America. That’s important because with his personality, he’s not about to engage in a trade war that provides no political upside.

So why do this at all? In this case, the steel and aluminum tariffs were floated to prop up the chances that a Republican candidate would win a congressional seat up for grabs in Pennsylvania, America’s steel capital. More to the point, this congressional seat was in a solid Republican district that Trump won by more than 20 points during the election. With all the pomp and ceremony of a reality show, Trump signed the tariff order surrounded by steel workers at the White House.

Yet the Democrats ultimately won that seat, and as for the 25 per cent tariff on steel and aluminum, almost every major trading partner has been granted an exemption, effectively rendering the penalties moot except for China, which was always the primary target.

China has already responded tit-for-tat with countervailing duties on pork and other agricultural products intended to apply maximum pressure on states that form Trump’s base. But to me, this is likely the opening salvos in trade negotiations that will begin in earnest later this year. The endgame will see the U.S. standing firm on the transfer of intellectual property, with the quid pro quo likely to be more favorable treatment for Chinese imports. The trick is wading through the midgame, as both sides play to the gallery, likely causing additional volatility in the financial markets.

There are positives to Trump’s approach. When he came into office, he threatened to leave NATO. His rationale was that most of the NATO partners weren’t carrying their fair share of the costs. Within months, the other NATO countries started upping their contributions. Clearly, his threat worked. 

He also got North Korea to the bargaining table, something that no other president has been able to do. In the lead-up to negotiations with North Korea, Trump has maintained the maximum-pressure campaign and appointed two hardline staffers (John Bolton as the new national security advisor and Mike Pompeo as Tillerson’s replacement for secretary of state) to act as his supporting cast. I suspect Trump sees a successful North Korea summit as the best chance to turn around his numbers. Because of its importance he likely will get a favorable outcome, which can be good and bad. 

In the short term, a clear victory would be a positive for the financial markets as it would provide stability in a region that’s strategically and economically important. On the downside, it will support Trump’s position that his negotiating approach is spot-on, meaning we’re likely to see more of the same in the coming months.

The challenge is to manage a well-thought-out investment strategy that takes advantage of Trump’s bluster while managing the risk that his altered universe may become reality. Bluster creates buying opportunities while this “altered reality” traumatizes.

And there lies the rub. Weighing the probability of taking a simple long or short position based on potential outcomes that are personality dependent is almost impossible. But if we enhance buy and sell decisions with options, we can exponentially increase the chance of a positive outcome. At a minimum, we get paid to assume the risk. 

To that point, we’re collecting premiums from the sale of option contracts in the current environment that are about double what we were collecting at the end of last year. Higher premium provides cash flow for investors seeking tax-advantaged income (option premiums are taxed as a capital gain in Canada) and provides a hedge against downside movements, which should benefit investors notably in the second and third quarter of 2018.

Think of this as our strategy to reduce the fallout from Trump-induced chaos.

TOP PICKS

Richard Croft's Top Picks

Richard Croft of R.N. Croft Financial Group shares his top picks: short puts on Netflix, Facebook and Altaba.

SHORT PUT NETFLIX (NFLX.O)

  • NFLX current price: US$326.00
  • Sell NFLX Sept. 300 put: US$23.00
  • Acquisition cost: US$277.00

If Netflix is trading above US$300 per share in September 2018, the put will expire worthless and the investor will pocket the premium received.

If Netflix is trading below US$300 per share, the put is assigned and the investor is required to buy shares at US$300 per share. However, the net acquisition cost is US$277, which is the US$300 strike price less the US$23 per share option premium.

SHORT PUT FACEBOOK (FB.O)

  • FB current price: US$187.00
  • Sell FB Sept. 185 put: US$10.00
  • Acquisition cost: US$175.00

If Facebook is trading above US$190 per share in September 2018, the put will expire worthless and the investor will pocket the premium received.

If Facebook is trading below US$190 per share, the put is assigned and the investor is required to buy shares at US$190 per share. However, the net acquisition cost is US$177.50, which is the U $190 strike price less the US$12.50 per share option premium.

SHORT PUT ALTABA (AABA.O)

  • AABA current price: US$75.65
  • Sell AABA Oct. 75 put: US$5.00
  • Acquisition cost: US$70.00

If Altaba is trading above US$75 per share in October 2018, the put will expire worthless and the investor will pocket the premium received.

If Altaba is trading below US$75 per share, the put is assigned and the investor is required to buy shares at US$75 per share. However, the net acquisition cost is US$70, which is the US$75 strike price less the US$5.00 per share option premium.

 

DISCLOSURE PERSONAL FAMILY PORTFOLIO/FUND
NFLX N N Y
FB N N Y
AABA N N Y

 

PAST PICKS: JUNE 15, 2017

Richard Croft's Past Picks

Richard Croft of R.N. Croft Financial Group reviews his past picks: A bear call spread on the iShares 20 year treasury Bonds ETF, buying the BMO Put Write ETF, and a covered call on BCE.

BEAR CALL SPREAD ON THE ISHARES 20 YEAR TREASURY BONDS ETF (TLT.OQ)

  • Sell TLT Dec. 126 calls: US$3.60
  • Buy TLT Dec. 135 calls: US$1.10
  • Net per share credit: US$2.50

On Dec. 15, 2017, TLT closed at US$128.35. The short December 126 call option closed in-the-money at a value of US$2.35. We would have to repurchase the option at that price. There was a $2.50 net credit on the original position that would have to be closed out at US$2.35, netting a 15 cent profit. The return on the position was 6 per cent ($0.15 divided by $2.50).

BUY BMO PUT WRITE ETF (ZPR.TO) at $19.02

  • Recommended at: 19.04
  • Now: 17.95
  • Return: -5.77%
  • Total return: -0.15%

Disappointing results for the holding period, though it was essentially flat. Shares closed at $17.87 on Friday and investors would have received 9.5 cents per share in 10 monthly dividends since June 2017. Accounting for the cash flow from the dividends, which was the rational for the recommendation, the position lost 1.29 per cent since June 2017.

BCE COVERED CALL (BCE.TO)

  • Buy: BCE at $59.32
  • Sell: BCE December 60 calls at $1.25

At the December option expiration, BCE closed at $61.35. The calls would have been assigned and the investor would have sold their position at $60 per share. The six-month return on this covered call was 3.25 per cent calculated as follows: $60 exercise price plus $1.25 premium divided by the initial purchase price $59.32. Investors would have also received $1.435 in dividends during the holding period, which would bring the total return on this trade to 5.67 per cent.

Total return average: 3.84%

 

DISCLOSURE PERSONAL FAMILY PORTFOLIO/FUND
TLT N N Y
ZPW N N N
BCE Y   Y

 

FUND PROFILE

CPC Option Writing Pool
Performance as of: April 30, 2018

  • 1 Month: 0.58% fund, 2.03% index
  • 1 Year: 6.43% fund, 4.97% index

* Index: MX Covered Call Index.

TOP HOLDINGS

  1. iShares S&P Canadian Preferred: 29.87%
  2. Apple: 6.77%
  3. Premium Income: 6.49%
  4. CP Rail: 4.99%
  5. BCE 3.55 12/31/49 Preferred: 4.46%

WEBSITE: www.croftgroup.com
BLOG: www.optionmatters.ca