The Time To Hedge Is Now! February 2015 Update
Summary Brief overview of the series which began April 30, 2014. Why buy-and-hold investors should consider hedging. Current buy prices on some of my preferred put options. Discussion of the risks inherent to this strategy versus not being hedged. Back to January 2015 Update Strategy Overview If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this Instablog . In the Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. Part II of the December explains how I have rolled my positions. I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. Why Hedge? With the current bull market having run more than 70 months, it is now more than double the average duration (30.7 months) of all bull markets since 1929. The current bull is now longer in duration than all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, and I will be the first to admit that I am probably earlier than I suggested at the beginning of this series. However, I do feel confident that the probability of experiencing another major bear market will rise in the coming year(s). It may be 2015, 2016 or even 2017, before we take another hit like we did in 2000-2002 or 2008-09. But I am not willing to risk losing 50 percent (or more) of my portfolio to save the less than two percent per year cost of a rolling insurance hedge. I am convinced that the longer the duration of the bull market lasts the worse the resulting bear market will be. I continue to base my expected hedge position returns on a market swoon on 30 percent, but now believe that the slide could be much worse as this bull continues to outlive its ancestry. Current Premiums on select Candidates In this section I will provide current quotes and other data points on selected candidates that pose an improved entry point from the last update. All quotes and information are based upon the close on Friday, January 30, 2015. I am calculating the possible gain percentage, total estimated dollar amount of hedge protection (Tot Est. $ Hedge) and the percent cost of portfolio using either the “Last Premium” amount shown or the middle of the range between the “bid” and “ask” premiums. The last premium paid on the last transaction of the day generally provides an accurate example of the cost and potential for each trade, except when the last premium is either at or beyond either the bid or ask premium. When the last premium is at or beyond either the bid or ask premium I chose to use the mid-point between the bid and ask premium. You may need to adjust your bid slightly higher if you do not get a fill, but a few pennies does not ruin the return potential on the suggested option contracts. Please remember that all calculations of the percent cost of portfolio are based upon a $100,000 equity portfolio. If you have an equity portfolio of $400,000 you will need to increase the number of contracts by a factor of four to gain adequate coverage. Also, the hedge amount provided is predicated upon a 30 percent drop in equities during an economic recession and owning eight hedge positions that provide protection that approximates $30,000 for each $100,000 of equities. So, you should pick eight candidates from the list and make sure that the hedge amounts total to about $30,000. Since each option represents 100 shares of the underlying stock, we cannot be extremely precise, but we can get very close. If the market drops by more than 30 percent I expect that we will do better than merely protect our portfolios because these stocks are very likely to fall further and faster than the overall market, especially in a crash. Another precaution: do not try to use this hedge strategy for the fixed income portion of your portfolio. If the total value of your portfolio is $400,000, but $100,000 of that is in bonds or preferred stocks, use this strategy to hedge against the remaining $300,000 of stocks held in the portfolio (assuming that stock is all that is left). This is also not meant to hedge against other assets such as real estate, collectibles or precious metals. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $24.24 $8.00 $15.00 $0.25 $0.55 $0.40 1650 $3,960 0.24% GT stock is actually slightly lower than it was at the time of the last update. But the potential gain is still good if you can get in near the latest premium paid. I don’t expect a major drop in share price without a recession, but we could see some gradual downside movement over the coming months. You will still need six January 2016 GT put option contracts to cover one eighth of a $100,000 equity portfolio. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $78.25 $20.00 $55.00 $1.15 $1.60 $1.30 2592 $3,370 0.13% We need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. The pricing in the January contracts has become more favorable. This is a good time to buy. In a recession, remodeling and painting projects get put on hold. United Continental Holdings (NYSE: UAL ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $69.37 $18.00 $35.00 $0.75 $1.26 $0.95 1627 $3,210 0.19% We need two January 2016 UAL put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. In the last update I used the June 2015 contracts; currently the January 2016 contracts are more cost effective than the June 2015 contracts. Travel is one of the first expense items to get cut by businesses during a recession. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $62.10 $16.00 $40.00 $0.90 $1.15 $1.00 2300 $4,600 0.20% We will need two January 2016 KMX put options with a strike of $40 to complete this position for each $100,000 in portfolio value. In the last update I used contracts with a $35 strike price, but the higher strike on these contracts will kick in sooner and afford us protection sooner in a downturn. The cost has gone up but the higher strike is worth it. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $75.55 $22.00 $42.00 $1.04 $1.26 $1.10 1718 $3,780 0.22% We need two January 2016 RCL put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. RCL stock price has fallen since the last update but this candidate still offers a good return potential and should drop like a sinking ship during a recession. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $84.63 $20.00 $56.50 $1.10 $1.25 $1.20 2942 $3,530 0.12% We need only one January 2016 LB put option to provide the indicated loss coverage for each $100,000 in portfolio value. Those of you who have been following the series will notice that I continue to increase the strike price from $50 to $56.50 to have our hedge protect us sooner. I do so whenever the option premiums allow us to do so at a reasonable cost. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $74.50 $30.00 $50.00 $1.10 $1.25 $1.15 1639 $3,770 0.23% We need two January 2016 MAR put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Once again, business travel will suffer in a recession and MAR profits will be a victim. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $55.03 $12.00 $35.00 $0.95 $2.10 $1.20 1817 $4,360 0.24% We will need two January 2016 TPX put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. TPX share price has rebounded bringing the stock back into the cross hairs for the strategy. Creation of new households will slow dramatically during a recession and the purchase of a new bed is something that gets put off until better economic times. I have chosen a premium price near the low end of the range but above the last premium paid price of $1.14. Micron Technology (NASDAQ: MU ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.27 $10.00 $19.00 $0.25 $0.29 $0.27 3233 $3,492 0.11% We need four July 2015 MU put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. I switched from the January 2016 contracts because the July has become more cost effective at a higher strike. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.81 $15.00 $27.00 $0.47 $0.55 $0.50 2300 $3,450 0.15% We need three July 2015 MS put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. MS seems to me to be one of the more susceptible of the big banks in a downturn. Recessions usually do not treat the financial sector well and MS has a history that makes it a favorable candidate. Seagate Technology (NASDAQ: STX ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $56.44 $24.00 $40.00 $0.40 $0.48 $0.45 3456 $3,110 0.09% We will need a total of two June 2015 STX put options with a strike of $40 to complete this position at current pricing levels for each $100,000 in portfolio value. In an unusual move I dropped the strike price from $45 to $40 because the cost had gotten too high on the $45 strike contract. Having said that, there are more efficient options listed above so I would be inclined to wait on this one for better pricing. E*Trade Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Mid-range Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $23.05 $7.00 $20.00 $0.82 $1.03 $0.90 1344 $3,630 0.27% The position shown above would require three July 2015 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Remember that these options expire in July 2015 and will require us to replace them at additional cost if the bull market is sustained. The cost has come down enough to put this candidate in play for the strategy. Yet there are better choices so I will wait a little longer for better pricing or use another candidate for my hedge. Sotheby’s (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $42.55 $16.00 $30.00 $0.40 $0.80 $0.70 1900 $3,990 0.21% We would need three July 2015 BID put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. This candidate stock has risen enough to provide a reasonable return. BID is really a play on the slowing of the Chinese economy, and specifically on the falling real estate prices. As newfound wealth created from overbuilding begins to deteriorate, purchases of art and collectibles loses its glamour. BID always seems to fall precipitously when there is a global recession. Level 3 Communications (NYSE: LVLT ) option costs have risen and are too high to be considered at this time. If the situation changes I will include the candidate in a future update. Summary My top eight choices from the list above includes LB, KMX, GT, WSM, MAR, RCL, TPX and UAL. That group (using the put option contracts suggested above) should provide approximately $30,580 in downside protection against a 30 percent market correction at a cost of 1.57 percent of a $100,000 portfolio. None of the candidates will need to be replaced until next January thereby keeping the cost below two percent for nearly a year. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our new option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration beyond January 2016, using from up to three percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins early in 2015; but if the bull can sustain itself into late 2015 or beyond, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge. Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I either hold put options in the stocks listed or will be buying them in the next week.