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By Jason Pearce

Numbers Deception

Mark Twain allegedly said, “Figures don’t lie, but liars figure.”  This can certainly be a true statement when investigating a market’s ROI.

Suppose you find a market that has averaged a positive annual return over the last decade.  Based on this information, does that mean the investor who owned it for the entire ten years made money?

Not necessarily.  It is quite possible he could have lost money on the investment, even though the average annual return was positive.  We’re not even talking about the impact of various account fees, commissions, etc., either.

It is possible for a market to have a positive annual return and simultaneously produce a negative compounded return.  For example, consider a market that gains +20% one year, loses -18% the second year, gains +20% the third year, and then loses -18% the fourth year.

At the end of four years, the average return on this market is a +1% gain.  However, the compounded return on the investment shows a -3.17% loss.

Volatility = Destruction

The higher the market’s volatility, the lower the compound returns.  If the size of the annual changes in the prior example were doubled to show two years with +40% gains and two years with -36% losses, the average return would double to a +2% gain, while the negative compounded return on the investment would increase just over six-fold to a -19.72% loss.

Even if the losses were smaller in proportion to the gains, the higher volatility would still be accompanied by an increase in the damage.  What if the market gained +40% in year one, lost only -30% in year two, gained +40% in year three, and lost –30% in year four?

 

 

The good news is that the average return on the market jumped substantially to a +5% gain.

The bad news is that the negative compounded return on the market still increased to a -4% loss.

So even though the average return is five times bigger than the market with two years of +20% gains and two years of -18% losses, the negative compounded return still increased as well.

Also, it does not matter one bit what order those returns are in.  If the market had gained +40% for two consecutive years before experiencing the two -30% losing years, the end result would be the exact same average and compound returns.

Leveraged ETFs

Warren Buffett once said, “Derivatives are financial weapons of mass destruction.”  If we’re talking about ETFs, I am inclined to agree with him.  Especially leveraged ETFs.

 

Many ETFs are constructed to match the daily returns of an underlying market.  Therefore, they have to be re-balanced every day.  Using the same math as above, if the market gains +25% and then loses -20% the average return is a positive +2.5%, but the compounded return is 0%.  Despite the fact that the percentage gain is larger than the percentage loss, you still would not have any gains to show for it.

But it gets even worse with leverage!

Many ETFs offer leverage that reflect two or even three times the daily returns of an underlying market.  If the underlying market gains +25% and then loses -20%, a double-leveraged ETF would gain +50% and then lose -40%.  As you would expect, the average return is a positive +5%, which is double the average return of the underlying market.

But the compounded return is where you take the hit.  Instead of treading water like the compounded return of the underlying market, the double-leveraged ETF sports a -10% loss.

 

Triple-leveraged ETFs are like jumping out of the frying pan into the fire.  The results of the triple-leveraged ETF in this same situation would be a gain of +75% and then loss of -60%.  The average return jumps to a positive +7.5% and the compounded return soars to a -30% loss.

How awful is that?  The 3x ETF has an average return that is only 50% bigger than that of the 2x ETF, but the compounded return is three times bigger than that of the 2x ETF.

Real World Examples

Let’s take a look at how an ETF performed vs. its leveraged version.  In particular, we’ll track the most popular ETF on the planet, which is the S&P 500 Index SPDR (SPY).  This ETF simply tracks the S&P 500 Index and uses no leverage.

We are going to look at the returns for 2007 thru 2012 to show the performance during a major bear market and the recovery that followed.

SPY posted a +3.2% gain in 2007, a -38.2% loss in 2008, a +23.4% gain in 2009, a +12.8% gain in 2010, a -0.2% loss in 2011, and +13.4% gain in 2012.

The average annual return over this six-year period was a +2.4% gain.  However, the compounded return was only a +0.5% gain.

When it was all said and done, a Buy and Hold strategy for this ETF would have been basically flat over this six-year timeframe.  Of course, we’re only talking about the money here.  If we take into consideration loss of opportunity, loss of sleep, loss of hair, etc. then the SPY investors probably suffered greatly!

If you think you can handle the heat and want to get double the leverage in the S&P ETF, the “astute” investor could have bought the Ultra S&P 500 Proshares (SSO) instead.  This ETF targets double the daily return of the S&P 500 Index.

SSO posted a -4% loss in 2007, despite the fact that the underlying market posted an annual gain.  There’s the first big red flag right there!  This ETF then posted a -68.2% loss in 2008, a +45.5% gain in 2009, a +25.6% gain in 2010, a -3.4% loss in 2011, and +30% gain in 2012.

The average annual return over this six-year period was a +4.25% gain.  However, the compounded return produced a -30% loss.  This is a much different outcome than the investor who held the non-leveraged ETF experienced.  While his million dollar nest egg was now sitting at $1,005,000, the leveraged investor’s million dollar nest egg has shrunk to $700,000!

 

So what if the investor had held a bearish double-leveraged ETF instead of a bullish one?  Well, the results would be even worse.

The Ultrashort S&P 500 ProShares (SDS) ETF targets double the inverse of the daily return of the S&P 500.  If the S&P gains 5%, SDS should lose 10%.  If the S&P loses 5%, SDS should gain 10%.  Capisce?

SDS posted a -6.8% loss in 2007, a +30.9% gain in 2008, a -50.5% loss in 2009, a -32.2% loss in 2010, a -18.8% loss in 2011, and -29.8% loss in 2012.

As a result, the average annual return over this six-year period was a -17.8% loss and the compounded return resulted in a devastating -76.7% loss.  You probably shouldn’t even calculate what would have happened to the leveraged investor’s million dollar nest egg with this debacle.

Fool’s Gold

Here’s a recent example for the gold bugs and the commodity investors.  Let’s look at an ETF for gold miners.  This has been a popular one over the last few years.

The Gold Miners ETF (GDX) tracks the NYSE Arca Gold Miners Index and uses no leverage, but that doesn’t mean it’s not volatile.  This ETF posted a -13% loss in 2014, a -25.3% loss in 2015, and +52.4% gain in 2016.

Although the average annual return for GDX during this three-year hold period was a +4.7% gain, the compounded return was a -1% loss.

The triple-leveraged version of this ETF is the Gold Miners Bull 3X Direxion (NUGT).  If you’re looking for trouble, you will certainly find it here!

NUGT posted a -59.2% loss in 2014, a -78.2% loss in 2015, and +57.2% gain in 2016.

 

The average annual return for NUGT during this three-year hold period was an atrocious -26.7% loss and the compounded return was an unbelievable -86% loss.  That’s certainly a lot more than triple the -1% loss that the GDX unleveraged ETF experienced during the same period.

Using the WMDs

Leveraged ETFs do have their place in a trader’s arsenal.  A trader can amplify their gains in a strong trending market by using leveraged ETFs (provided that he’s on the right side of that trend, of course!)

As a matter of fact, the returns on a leveraged ETF can even overshoot the target returns when a trend is strong enough.

Once a market starts to get a little choppy or breaks trend, though, things go south quickly.  The losses on the leveraged ETFs can accelerate.  Therefore, traders must remain vigilant and be willing to bail out at the drop of a hat.  Leveraged ETFs may not be the ideal instruments for a long-term trader to trade and it’s definitely not the right instruments for an investor to allocate their investment capital to.

Having investigated the dangers of buying them, leveraged ETFs can actually offer a great trading opportunity for the trader who’s willing to follow Robert Frost’s advice and take the road less traveled by.  That path is found on the short side of the trade.

 

Think about it: if an ETF is going to take it on the chin through leveraged decay and volatility, why shouldn’t a trader take advantage of it by being positioned on the short side?  A lot of the leveraged ETFs reflect the daily percentage change of the underlying market, so it works against the investor over time.  The longer the hold period, the bigger the losses on the ETF.  This works directly in favor of the short seller because he is betting on depreciation in the value of the ETF.

Clarification

It’s important to understand that a strategy of shorting ETFs is not based on the idea of being bearish on the underlying market.  Rather, it is based on the idea of being bearish on the value of the ETF itself.

Traditionally, if an ETF trader is bullish on a market he would buy the ETF or even some of the leveraged ETFs.  If the trader used the strategy we are discussing, however, he would short the bear ETFs in lieu of buying the bull ETFs.  Conversely, a trader with a bearish opinion of the underlying market would short the bull ETFs instead of entering a long position in the bear ETFs.

Know When to Tap Out

Despite the fact that the short side of a leveraged ETF has extremely favorable probabilities for the trader, it does not mean that it is a risk free trade.  You have to make sure you have position size limits and an exit strategy for the trades that are unprofitable.  Even many casinos still impose limits despite the fact that they have the house advantage.  It’s not done to protect the gambler; it’s to protect the casino!

 

Even the best fighters know when they should tap out.  This is why they will live to fight another day.  So when you are trading leveraged ETFs, it’s important to know where to tap out.  To that end, I’m going to give you a couple of exit techniques that you may want to investigate to see if they fit your trading strategy.

The first is to set an exit level on a percentage move.  First, you would want to measure the sizes of all the countertrend rallies that have occurred in the last year or so.

If you see consistency in the size of the bounces, say a series of 5%, 4.6%, 4.2%, 5.5%, and 4.8%, you could use the number that is two or three times the average as your exit point.  In this case, the average size bounce is 4.82%.

In the same way that many trend followers use a multiple of a market’s Average True Range (ATR) for an exit signal, a trader could exit a short ETF position if a countertrend rally is some multiple of what the market has been experiencing during the decline.  In the case where the average size bounce is 4.82%, perhaps the exit signal would be triggered by a countertrend rally of 9.6% (double the average) or 14.5% (triple the average).

Another exit technique that a trader could employ would be classic technical tools like moving averages, Bollinger bands, price envelope breakouts, etc.  Simply put, a violation of resistance (preferably on a closing-basis) would tell you that the downtrend is being challenged and that the bears are not in complete control.  If the profits from your short ETF position are no longer “easy money” it’s time to get out and look for better opportunities.

Market Neutral Position

Another idea for traders to consider instead of traditional trend following is to construct a market neutral position.  After all, both the bullish and bearish leveraged ETFs can lose money over the same period.

A trader could construct a market neutral position by allocating half of the capital into a bullish leveraged ETF and the other half into its corresponding bearish leveraged ETF.  That way, the trade is making money on both ETFs if the market stays choppy and trends fall apart.  But even if the underlying market starts to form a strong trend at some point, at least one of the ETFs will continue to erode in value and at least partially offset the other ETF that is increasing in value.

In a market neutral position, a trader could set stops/exit points for the entire position (the bullish and bearish ETFs combined) or the exit criteria could be determined individually for each side of the position.  There is no right or wrong answer here.  Each trader needs to do the research to figure out what is best for their own strategy.

Don’t Tolerate Losers

A trading strategy that focuses on shorting leveraged ETFs can put the odds squarely in favor of the trader.  A majority of trades should work out profitably.  But keep in mind that shorting leveraged ETFs is still not a risk free trade!  It is important that a trader still manage the risk on the trade by setting loss limits.

 

Given the favorable probabilities of shorting leveraged ETFs, it makes sense that the trader should have even less tolerance for losses from this strategy than that of another strategy where the playing field is level.  If a trade is not working, especially if it’s showing a growing loss, it’s time to cut bait and fish elsewhere.  You’ve got much bigger fish to fry.  The next one should be easier to catch, too.

Editor’s Note: We had access to the institutional database at ETF Global for researching this article.

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CorneliusLuca

 

 

 

 

 

Michael Martin speaks with foreign exchange expert Cornelius Luca in this podcast episode. Topics include European elections and Brexit.

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While you’re there, please leave a review about the show. If you’ve learned anything valuable, please consider sharing that in the review.

 

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optionvega

The following is an excerpt from Managing Expectations by Tony Saliba

Option Vega

Compared to a stock or bond, options are contracts with a shelf- life and are exposed to a range of unique risks – greeks (i.e. delta, gamma, theta, vega, rho) – each of which measures the sensitivity to some variable including time, volatility, and movement.

Experienced derivative traders know that option prices actually boil down to the market’s expectancy of future volatility of the underlying asset, since all the other determinants of an option’s price—the underlying price, time to maturity, interest rate, and strike price—are objective. Volatility is the subjective unknown, and seldom does an option’s actual, realized volatility replicate the implied volatility reflected in its current traded valuation.

Vega Defined

Interestingly enough, option vega is the one option greeks not represented by a formal Greek letter – it represents the sensitivity of an option to the changes in implied volatility for a term equivalent to its expiration date. Vega is an estimate of much the theoretical value of an option changes when implied volatility changes one percent.

• Vega is a number that expresses in what direction and to what extent the option price will move if there is a 1% change in the options implied volatility.

• Vega is the first mathematical derivative of an option price with respect to the underlying asset volatility.

• Option vega is equal for both call and put options with the same month and strike price (e.g., if the SPY August 190 call has a vega of .35, the August 190 put will also have a vega of .35).

• Options with less time to expiration have a lower option vega comparatively to options with a long time to expiration.

• Options are most sensitive to changes in the options implied volatility of the underlying asset when they are at-the-money calls or puts.

• Out of the money and in the money options are not nearly as affected by volatility (relative to at-the-money options).

• Option vega can be hedged with another option only. The best vega hedge is a nearby strike of the same expiration month. This relationship is reduced the further the hedged long month is from the hedged short month.

Typically, options professionals express vega as a distinct measure. For the sake of simplicity, professionals multiply vega by the current level of volatility in an effort to make it correspond to a standard percentage move in asset volatility level. If S&P 500 (SPX) volatility is 28% and the option vega is .2, the option will theoretically gain or lose 20 cents when the volatility rises (falls) by one percentage point to 27%.

Long (purchased) calls and puts always have positive vega. Short (sold) calls and puts always have negative vega. A call and put with the same strike price and month will have the same vega. Underlying futures and securities have zero vega as their values are linear and thus not affected by changes in implied volatility.

Vega risk is the risk due to changes in volatility, or the “volatility of volatility”. A strict understanding of vega risk is important in any options strategy or position, as it can generate unforeseen risk, even if all the other greeks are hedged perfectly.

Options vega is similar in shape to both options gamma and theta as an options vega reaches its plateau when it’s at the money. An option’s vega differs from both gamma and theta whereas vega generally increases with time while it generally decreases (with time) for both gamma and theta. That being said, the vega of an at the money option is fairly dependable to volatility changes. However, options further away from the money are not as stable given the complexity of changes in the volatility structure.

Practicality & Reality of Vega

A good trader needs to understand his risk and be ready to address that risk when personal and prearranged risk limits are breached. The trader’s ability to interpret vega is of utmost importance as its purpose is to gauge the trader’s position sensitivity to changes in the assets implied volatility – one of the largest and most unpredictable risks the trader will face.

Vega can be used to evaluate risk across products, strike prices, and time frames although greater caution needs to be taken here as complexity begets complexity. Consider an options portfolio with random long and short positions spread out amongst various strike prices along with different times to expiration. A seasoned trader will quickly recognize that the “net vega” published by a trading model is at-best “raw vega”. Like the other greeks mentioned, vega is an estimate and subject to wise discernment. Variables including options skew (see Chapter 11) and term structure (see Chapter 12) can and do alter the true value of an option’s vega.

Additionally, the majority of an option price “fair-value” is derived by either a Black-Scholes model or iteration thereof. The options model produces a “fair-value” of an option based on five variables including – the underlying price, the strike price, the term of the option, the interest rate, and the current volatility. A skilled trader will realize (usually through a bad experience) that an options model is using a static volatility input and thus, the “fair-value” option price produced will then assume a static volatility environment. Consequently, option traders realize that options vega is both an estimate and subject to interpretation. It’s difficult – if not impossible – to measure the real vega sensitivity of an options portfolio with a static, human recorded asset volatility.

Under the conventions of the Black-Scholes model, underlying asset return volatility is constant, which is rarely supported by research nor is it realistic! Furthermore, option implied volatility fluctuates over any given period of time – thus the importance of vega.

Options Vega and Options Strike Price

In theory it’s easy to conceptualize. An option vega – it’s sensitivity to changes in implied volatility – is at its greatest point with an at- the-money option. An option’s vega becomes less and less the further your option is from the at the money strike. What that means is a 1.00-delta call will have almost no vega, a .70-delta call will have more vega compared to a 1.00-delta call and less than a .50-delta call. Similar would hold true for puts.

In a perfect world – one that uses a static volatility – equidistant strike prices would have the same vega. Other words, mathematically speaking a 5% out of the money call should have the same exact vega as an equidistant 5% out of the money put. Yet, due to options implied skew, it could be precisely true that an equidistant 5% out of the money call could have more/less vega than a 5% out of the money put.

A successful trader will have a solid understanding of both the textbook and realistic definition of options vega. Most products have some sort of implied volatility skew and that skew is not static – it changes with sentiment, time, and supply versus demand. As options trades evolve to a strategy and then a position, it’s essential that a trader understand vega on an intuitive level.

Options Vega and Time

• Vega increases with longer time to expiration and decreases with less time to expiration.

• The term structure of implied volatility describes, for a given exercise strike price at a given date in time, the relationship between implied volatility and option maturity.

It should be of little surprise that the less time to expiration the more reasonably accurate “the market” can be in assessing where the underlying will land at expiry. Similarly, more time to expiration equals less precision – more unknowns – on where the underlying will land. Thus, the more time to an option’s expiration – the more vega an option will have. This makes sense as time value makes up a larger percentage of the premium for longer-term options and it is the time value that is sensitive to changes in volatility. This results in a higher vega for options with longer time to expiration in order to compensate for the additional risk assumed by the seller.

A consistent options trader will not compare, net, add, or subtract the vegas of an options position resultant of various maturities. They will first know precisely where the long and short vega is BEFORE netting vega.

Vega and Volatility

Vega and implied volatility are certainly not the same thing but they are correlated. Vega tells us an option’s (or an option strategy or positions) sensitivity to implied volatility. Implied volatility is the premium – or extrinsic value paid for the option.

Theoretically speaking, if you isolate – underlying movement, time, and options skew – changes in volatility will affect option prices but change them differently. Option vega is greatest for options at-the- money options, and it is smaller for options completely out of the money or very deep in the money.

Said differently, if an option you’re long (purchased) is far out of the money and near worthless, it matters little how much the underlying’s implied volatility shifts, because the odds the option will suddenly become at the money or in the money are still considered relatively small.

If the option is deeply in the money, the chance that the option will suddenly become worthless with increased volatility is also relatively small. But if the option is at the money, which is on the edge of being worthless or valued, then even a relatively fractional change in the implied volatility in the price of the underlying asset can change the position. Thus, the reason why vega is at its highest point for at the money options.

This is an excerpt from Managing Expectations by Tony Saliba.

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bart chilton

Michael Martin speaks with former CFTC Commissioner Bart Chilton. Topics include position limits, Jon Corzine, and Dodd-Frank.

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By Jason Pearce

Prices in the North Could Head South

Everybody loves a good market bubble story!  If that’s you, you’re in luck because it looks like we may have one in play just over the border.  Although it doesn’t grab all the headlines here in the US, the housing market up in Canada is certainly a hot topic.

There are some analysts who liken the current Canadian housing market situation to that of the US housing market a little over a decade ago.  That’s not entirely accurate, though.  Don’t expect to see a foreign version of The Big Short in theaters anytime soon.

On the other hand, there are enough parallels between the US housing market demise and the current situation in the Canadian housing market that that one has to wonder if a major shakeup is imminent.

To the Moon

We all remember how ridiculous the housing prices got when the bubble in the US peaked in 2005.  But did you know that Canadian housing prices experienced a run-up, too?  Even better, the Canadian market did not collapse when ours did.  It stayed elevated until 2007 before the financial crisis finally pulled the rug out from under everything.

Fast forward to a few years later and the Canadian housing market has fully recovered.  It surpassed the prior peak by a country mile.  Here’s the real kicker: Canadian housing prices have exceeded the 2005 US housing prices by a large margin!

 

Some might immediately think that the higher price reflects the exchange rate.  The Canadian dollar is significantly lower than the US dollar, so Canadian houses should naturally show a higher price tag.  But when you compare the average house prices for Canada and the U.S. with both denominated in U.S. dollars, it reveals just how expensive the Canadian housing market is.  It has surpassed the U.S. bubble’s peak.

 

Adjusted for inflation, not only has the Canadian housing market blown past the peak of the US housing bubble, but it has now matched the real estate bubble of Japan from the 1980s.  That certainly didn’t end well.

The Lead Sled Dogs

Vancouver and Toronto are the two Canadian markets leading the charge in this housing bubble.  Their price gains out-paced the rest of the country.  So you can’t say that someplace like Ottawa is just as frothy as Toronto.  However, these top growth markets are still having an impact on the entire Canadian housing market.

 

To get a feel for how far things have gone, compare the Vancouver and Toronto markets to places like Miami or San Francisco during the US housing bubble.  You quickly surmise that these two Canadian cities have outperformed the cities that led the charge during the US boom.

The Bigger They Are…

Since Vancouver and Toronto went up more than the rest of the metro areas, it stands to reason that they should also go down the most.  But that does not mean the other areas will not also go down decline.

But it is possible that the negative psychological effect of a falling housing market could increase the rate that other metro areas go down with Vancouver and Toronto.

What we are talking about here is beta.  For example, if one metro area went up 50% as much as Vancouver and Toronto, we’d say it has a beta of 0.5.  But what if the beta increases to 0.6 or 0.7 during a decline?  It would mean declines of 60% or 70% as much as Vancouver and Toronto.  It’s certainly not a guarantee that we would see a beta increase, but you can’t rule it out either.

No Subprime Crisis

One major difference between the US housing bubble and the current Canadian housing market is that Canada doesn’t have a major chunk of the real estate market tied up in subprime garbage.  The higher lending standards of the Canadian banks are the whole reason that they didn’t suffer the same fate as the US when the last housing bubble popped.

 

Currently, subprime loans make up about 5% of all mortgages issued in Canada.  When the crisis hit the US market, roughly 21% of all U.S. mortgages were subprime.  Therefore, the Canadian housing market is not quite as risky as the US housing market was a little over a decade ago.

But notice that I did not say that the Canadian housing market is risk free.

Home Owners Are Stretched

Predicting where a bubble will peak is a tough business.  But you can get a sense of how mature the run is when the buying capacity is stretched.  When there’s no one left to buy, there’s no more upside for the market.

 

Right now, buying capacity is spread pretty thin.  The Canadian household debt-to-income ratio is well beyond what it was at the 2007 peak.  Ominously, the Canadian household debt-to-income ratio of nearly 170% is getting awfully close to where the US household debt-to-income ratio peaked during the US housing bubble.

The household debt-to-income ratio does not take mortgage fraud into account, either.  Lending agency Equifax Canada reported that the number of “suspicious” mortgages have increased 52% over the last three years.  With two-thirds of the mortgages in Ontario flagged as “suspicious” it is conceivable that households are stretched even further than the official numbers state.

Wheels Set In Motion

The housing market may have finally peaked as the government took action to douse the speculative frenzy.  Last summer, British Columbia passed a law to make foreign buyers of Vancouver real estate pay a 15% tax.   Furthermore, the federal government changed the rules for all insured mortgages that make it more difficult for buyers to qualify.

 

Not surprisingly, the changes in Vancouver had a major impact on the market.  Over the last 12 months, home sales have plunged 40 percent and home prices have started softening as well.

The Next Shoe

Ontario has yet to reign in the out-of-control housing market.  Therefore, prices in Toronto are up nearly 23% from a year ago and supply is only half of what it was then.  Ironically, experts are saying that the crisis is actually the shortage of supply!

Despite the supply shortage, you have to wonder how much more housing prices can increase if there is not a corresponding increase in the buyer’s income.  As we’ve already seen, buyers are already stretched thin with a household debt-to-income ratio that rivals that of the US household debt-to-income ratio at the peak of the housing bubble.

History Repeats

When the Toronto housing market bubble finally pops, it won’t be a new experience for homeowners.  If history is any guide, it will not be a pleasant event.

Toronto housing prices peaked in 1958, softened for years, and finally bottomed out in 1964.  In 1966, prices finally returned to the 1958 peak.  That was an eight-year round trip.

The next major top occurred in 1974.  Housing went into an eleven year bear market and posted the final low in 1985.  It wasn’t until 1987 when the housing market finally matched the prior peak.  That’s a thirteen-year wait to breakeven for Canadian homeowners who bought in 1974.

The rebound off the 1985 low turned into a full-blown bubble.  It finally popped in 1989 and began a multi-year decline that didn’t end until 1996.  Adjusted for inflation, this decline knocked a whopping 40% off the housing prices.  Furthermore, it took a little over twenty years for the Toronto housing market to return to the 1989 peak.

 

Adjusted for inflation, current Toronto housing prices are substantially higher than where the last bubble peaked.  If history were to repeat, this will be followed by a multi-year bear market.  Investors who believe that “It’s different this time” are in for a rude awakening.

Nothing to Worry About

Logically, more housing market price gains similar to what has already occurred are economically unsustainable.  Besides, the housing market in Vancouver –one of the leaders in this bubble- is already slowing down significantly.

Despite these facts, there still isn’t much concern for the potential downside.  When people aren’t prepared for an adverse an event, that’s when they are the most vulnerable.

 

For example, while saying that the Canadian housing market growth may slow down, Moody’s Analytics said nothing about the growth actually stopping or even reversing.  Their big warning is that national house price growth will drop to from about 8% right now to about 2% by the end of 2018.

This is unsettling.  It reminds of the summer of 2005 when Ben Bernanke, the Chairman of the Council of Economic Advisers, said,” Housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong. We’ve got a growing economy, jobs, incomes. We’ve got very low mortgage rates. We’ve got demographics supporting housing growth. We’ve got restricted supply in some places. So it’s certainly understandable that prices would go up some. I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.”

 

Then in February 2006 when he was the new Fed chairman, Bernanke said, “The housing market has been very strong for the past few years . . . . It seems to be the case, there are some straws in the wind, that housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise, but not at the pace that they had been rising. So we expect the housing market to cool, but not to change very sharply.”

So much for the assuring words of the experts…

More Potential Catalysts

We already covered the reasons that the Canadian housing market bubble may have started to deflate.  Heck, it could even pop.  But what we did not get into are the other potential events that could raze the Canadian housing market.

What if the bull market in stocks pauses or even comes to an end?  Household wealth levels would decline.  Home values would likely get dragged down with it.

Canada is a big-time commodity producer.  Another break in the price of crude oil, gold, or the grain markets would have an adverse effect on Canada’s economy.  Housing markets would likely feel the impact.

If Ontario finally wakes up to the danger of the housing market bubble and changes the rules like BC did, we should expect the same outcome: a drop in both home sales and home prices.

 

What if the economy, the stock market, and commodities all stay strong and the boom times last?  Eventually, that could drive the Bank of Canada to decide that tighter monetary policy makes sense.  An increase in interest rates could become the proverbial straw that breaks the camel’s back.

How to Play It

It’s not like a trader or investor can “go short” on a Toronto condo or a Vancouver house.  And although the CME has futures contracts on major US cities like Miami, San Francisco, New York, Las Vegas, etc. there currently aren’t any for Canadian cities.  But perhaps one way to trade a decline in the Canadian housing market is to short their banks.

Right now, this may sound crazy.  Moody’s Investor Service says the Canadian banks would perform better in a housing market downturn than the US banks did.  The big Canadian banks have been around forever.  They have weathered the prior financial crises and came out on the other side.  Furthermore, they pay generous dividends and most of them have recently reported increased income.  What investor would want to sell their shares in a bank with such a great track record?

But that doesn’t mean that they haven’t experienced setbacks.  And it sure doesn’t mean that they won’t in the future.

According to the Toronto Stock Exchange, Canada’s banks are already being heavily shorted right now and in a much bigger way than similar-sized companies.  But according to the stock price of these banks, the short positions have been mostly wrong for months.  Why?  Because the price has been trending higher for months.

Trend Change Afoot

Despite the case for the Canadian housing bubble to pop, a trader should look for price confirmation before acting on any theories.  This is that timing part of the equation.

Right now, we may be finally getting that confirmation as many Canadian bank stocks have started to deteriorate over the last couple of weeks.

 

First off, some of the banks stocks may be establishing a classic Double Top pattern by trading within pennies of their prior highs and then stating to pullback.  Royal Bank of Canada (RY) and Bank of Montreal (BMO) both fit this bill as they neared the 2014 record highs and retreated.

 

Both of these stocks are now dangling just above technical support between their rising 50-day Moving Average and last month’s low.  A close below the 50-day MA and a break of a prior month’s low –neither of which have happened since November- could put further pressure on the stocks and drive it down to the widely-watched 200-day Moving Averages.  This could increase the odds that a major top is in place.

 

Toronto Dominion (TD) is even more intriguing.  This stock surpassed the 2014 record high by nearly $1-per-share and then pulled back sharply.  This is what I have coined the Wash & Rinse sell pattern.  By definition, this is a failed breakout pattern where a prior high is surpassed and then the market quickly reverses lower.  The Wash & Rinse can often lead to major declines.

 

Furthermore, Toronto Dominion got crushed on Friday as it dropped 5.31% and broke the rising 50-day Moving Average for the first time in five months.  The stock also plunged below a prior month’s low for the first time in nine months.  Ideally, a bounce back to last month’s low or the 50-day MA (old support, once it is broken, becomes new resistance) would materialize and allow for a nice entry point.  If successful, the position size could be increased aggressively if new corrective lows follow.

 

Finally, there are a couple of stocks that never got close to their prior highs.  They become short sale candidates by virtue of comparative weakness.  They are the worst-performing of the bunch and vulnerable to getting hit the hardest.  Bank of Nova Scotia (BNS) and CIBC (CM) are the two that I am talking about.  Is it any coincidence that CIBC has the highest real estate exposure and it’s one of the worst looking Canadian bank stocks?!

 

Bank of Nova Scotia already cracked support at the 50-day Moving Average and prior month’s low, while CIBC has not.  This means that Bank of Nova Scotia is currently more qualified for a short sale than CIBC.  Once CIBC has violated these same technical levels, it will show that it is also ripe for the picking.

Be Smart

Sometimes, traders think they’ve found the once-on-a-lifetime trading opportunity.  One that’s almost a sure thing.  One that could create the kind of fortune that lasts for generations.  Maybe shorting Canadian banks will be the most talked about trade next year and you’ll hear all the stories of the next John Paulson’s of Canada who made billions of dollars betting on it.

If you get into a trade and it starts to go your way, great!  You can short even more Canadian bank stocks if they keep dropping and your current positions are all showing open profits.  The winners take care of themselves so we don’t need to go too deep into a detailed discussion.

The problem, however, is that we could always be early.  Worse yet, we could even be completely wrong.  One never knows that a trading opportunity is a sure thing until it has gone on the record books as a matter of history.

How many people were shorting European bonds once the yields dropped to near zero percent?  Here we are a few years later and yields are now negative.  Although it seemed like a no-brainer at the time to bet on rising yields, it was completely wrong.  A lot of good traders broke their axe on that stone.

 

So do the smart thing and focus on managing your risk.  This should be your top priority.  There’s a great Wall saying, “Bulls make money, bears make money, but pigs get slaughtered.”  Don’t ever bet the farm on any trade idea and don’t add to a losing position.  As a matter of fact, the only thing you should do with a losing position is liquidate it.

 

 

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