Tag Archives: portfolio

Keeping A Small Nest Egg From Cracking

Summary A small investor can protect himself against a severe correction while maximizing his expected return by using a hedged portfolio, such as the one shown below. This portfolio has a negative hedging cost, meaning the investor would effectively be getting paid to hedge. This portfolio is designed for an investor who is willing to risk a maximum decline of up to 20%. Investors with lower risk tolerances can use a similar process, though their expected returns would generally be lower. Seeking Direction as Investor Concerns Mount As Seeking Alpha contributor Eric Parnell, CFA noted , (“Stocks: Perspectives On The Selloff”), the four-day decline in the S&P 500 index last week was the worst since October of 2011. The stock market slide coincided with fresh indicators of global economic weakness, including oil futures dropping below $40 per barrel on Friday. On Sunday night New York time, and Monday morning in Shanghai, the Shanghai Composit Index opened down sharply. CNBC aired a rare live Sunday evening broadcast (” Markets in Turmoil “) in response to the negative market news. During the broadcast, analysts and anchors debated whether the pullback would continue, and how investors should respond. I didn’t watch the entire broadcast, but the part I saw conformed to previous, similar specials: a guest expert says the pullback could be a buying opportunity, reiterates the importance of having a long term horizon, etc. In reality, no one knows what the future holds, but small investors can strictly limit their risk while remaining invested in the stock market. Another Way To Invest Small investors don’t have to live with worry that they might suffer an intolerable loss in the stock market. With a hedged portfolio, they can decide the maximum drawdown they are willing to risk, and invest confident that their downside risk is strictly limited in accordance with that. In the example below, we’ll show a sample hedged portfolio designed to protect a small investor against a greater-than-20% loss over the next six months while maximizing his expected return. We’ll also detail how an investor can build a hedged portfolio himself. The first decision an investor needs to make, though, is how much he is willing to risk. Risk Tolerance, Hedging Cost, and Potential Return All else equal, with a hedged portfolio, the greater an investor’s risk tolerance — the greater the maximum drawdown he is willing to risk (his “threshold”) — the lower his hedging cost will be and the higher his expected return will be. An investor who is willing to risk a 20% drawdown is in good company. Several years ago, in one of his market commentaries , portfolio manager John Hussman had this to say about 20% drawdowns: “An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).” Essentially, 20% is a large enough threshold that it can reduce the cost of hedging, but not so large that it precludes a recovery. Constructing A Hedged Portfolio In a previous article (“Backtesting The Hedged Portfolio Method”), we discussed a process investors could use to construct a hedged portfolio designed to maximize expected return while limiting risk. We’ll recap that process here briefly, and then explain how you can implement it yourself. Finally, we’ll present an example of a hedged portfolio that was constructed this way with Portfolio Armor ‘s automated tool. The process, in broad strokes, is this: Find securities with high potential returns (we define potential return as a high-end, bullish estimate of how the security will perform). Find securities that are relatively inexpensive to hedge. Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high potential returns net of their hedging costs (or, ones with high net potential returns). Hedge them. The potential benefits of this approach are twofold: · If you are successful at the first step (finding securities with high potential returns), and you hold a concentrated portfolio of them, your portfolios should generate decent returns over time. · If you are hedged, and your return estimates are completely wrong, on occasion — or the market moves against you — your downside will be strictly limited. How to Implement This Approach · Finding securities with high potential returns. For this, you can use Seeking Alpha Pro , among other sources. Seeking Alpha articles often include price targets for long ideas, and you can convert these to percentage returns from current prices. But you’ll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month potential returns. · Finding securities that are relatively inexpensive to hedge. For this step, you’ll need to find hedges for the securities with high potential returns, and then calculate the hedging cost as a percentage of position value for each security. Whatever hedging method you use, for this example, you’d want to make sure that each security is hedged against a greater-than-20% decline over the time frame covered by your potential return calculations. Our method attempts to find optimal static hedges using collars as well as protective puts. · Buying securities that score well on the first two criteria. In order to determine which securities these are, you may need to first adjust your potential return calculations by the time frame of your hedges. For example, although our method initially calculates six-month potential returns and aims to find hedges with six months to expiration, in some cases the closest hedge expiration may be five months out. In those cases, we will adjust our potential return calculation down accordingly, because we expect an investor will exit the position shortly before the hedge expires (in general, our method and calculations are based on the assumption that an investor will hold his shares for six months, until shortly before their hedges expire or until they are called away, whichever comes first). Next, you’ll need to subtract the hedging costs you calculated in the previous step from the potential returns you calculated for each position, and sort the securities by their potential returns net of hedging costs, or net potential returns. The securities that come to the top of that sort are the ones you’ll want to consider for your portfolio. · Fine-tuning portfolio construction . You’ll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you’re going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you’ll need to take into account the share prices of the securities. Stocks such as Priceline.com (NASDAQ: PCLN ), trading at more than $1200 per share, wouldn’t work in a $30,000 hedged portfolio, because the investor wouldn’t be able to purchase one round lot. Another fine-tuning step is to minimize cash that’s leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won’t need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a “cash substitute”: that’s a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor’s downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step. · Calculating An Expected Return. While net potential returns are bullish estimates of how well securities will perform, net of their hedging costs, expected returns, in our terminology, are the more likely returns net of hedging costs. In a series of 25,412 backtests over an 11 year time period, we determined two things about our method of calculating potential returns: it generates alpha, and it overstates actual returns. The average actual return over the next six months in those 25,412 tests was 0.3x the average potential return calculated ahead of time. So, we use that empirically derived relationship to calculate our expected returns. Example Hedged Portfolio Here is an example of a hedged portfolio created using the general process described above by the automated portfolio construction tool at Portfolio Armor. This portfolio was generated as of Friday’s close (results could vary at different times, depending on market conditions), and used as its inputs the parameters we mentioned for our hypothetical investor above: a $30,000 to invest, and a goal of maximizing potential return while limiting downside risk, in the worst-case scenario, to a drawdown of no more than 20%. Worst Case Scenario The “Max Drawdown” column in the portfolio level summary shows the worst case scenario for this hedged portfolio. If every security in it went to zero before the hedges expired, the portfolio would decline 18.67%. Negative Hedging Cost Although minimizing hedging cost was only the secondary goal here after maximizing potential return, note that, in this case, the total hedging cost for the portfolio was negative, -1.23%, meaning the investor would receive more income in total from selling the call legs of the collars on his positions than he spent buying the put legs. Best Case Scenario At the portfolio level, the net potential return is 17.79%. This represents the best case scenario, if each underlying security in the portfolio meets or exceeds its potential return. A More Likely Scenario The portfolio level expected return of 6.86% represents a more likely scenario, based on the historical relationship between our calculated potential returns and actual returns. Each Security Is Hedged Note that in the portfolio above, each of the three underlying securities – Netflix (NASDAQ: NFLX ), Facebook (NASDAQ: FB ), and DexCom (NASDAQ: DXCM ) is hedged. Hedging each security according to the investor’s risk tolerance obviates the need for broad diversification, and lets him concentrate his assets in a handful of securities with high potential returns net of their hedging costs. Here’s a closer look at the hedge for one of these positions, Netflix: As you can see in first part of the image above, NFLX is hedged with an optimal collar with its cap set at 21.92%. Using an analysis of historical returns as well as option market sentiment, the tool calculated a potential return of 21.92% for NFLX over the next six months. That’s why 21.92% is used as the cap here: the idea is to capture the potential return while offsetting the cost of hedging by selling other investors the right to buy NFLX if it appreciates beyond that over the next six months.[i] The cost of the put leg of this collar was $820, or 7.89% of position value, but, as you can see in the image below, the income from the short call leg was $770, or 7.41% as percentage of position value. Since the income from the call leg offset most of the cost of the put leg, the net cost of the optimal collar on NFLX was $50, or 0.48% of position value.[ii] Note that, although the cost of the hedge on this position was positive, the hedging cost of this portfolio as a whole was negative . Why These Particular Securities? Netflix and DexCom shares were included as primary securities in this portfolio because, as of Friday’s close, they were both among the top securities in Portfolio Armor’s universe when ranked by net potential return, and they had lower share prices than other securities similarly highly ranked. Recall from our discussion above about fine-tuning portfolio construction, that it can be difficult to fit round lots of securities with higher share prices in smaller portfolios. Facebook was included as a cash substitute because it had one of the highest net potential returns when hedged as a cash substitute. Possibly More Protection Than Promised In some cases, hedges such as the ones in the portfolio above can provide more protection than promised. For an example of that, see this post on hedging Netflix last year. Hedged Portfolios For Investors With Lower Risk Tolerance The hedged portfolio shown above was designed for a small investor who could tolerate a decline of as much as 20% over the next six months, but the same process can be used for investors who are more risk averse. Using data as of Friday’s close, we were also able to construct a hedged portfolio for an investor only willing to tolerate a loss of a tenth as much, 2% over the next six months. —————————————————————————– [i] This hedge actually expires in a little more than 7 months, but the expected returns are based on the assumption that an investor will hold his positions for six months, until they are called away or until shortly before their hedges expire, whichever comes first. [ii] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, the cost of this collar would likely have been lower. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

VDAIX: Vanguard’s Major Dividend Mutual Fund Needs Oil And Utilities

Summary VDAIX offers investors a great start to building a dividend portfolio. The fund is missing almost all exposure to the utility sector and to oil and gas. The expense ratio on the investor class of shares is .2%, which is higher than I would want to see for a long term holding. If an investor builds a portfolio around this fund they should be adding their own utility and oil exposure. CVX and COP offer great dividend yields. A very well diversified equity portfolio would also use some equity REIT exposure from another ETF. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. Despite my frequent use of ETFs in my personal investing, many retirement accounts still use mutual funds as a major source of their investing. When it comes to assessing the mutual funds, one of my earlier favorites is the Vanguard Dividend Appreciation Index Fund (MUTF: VDAIX ). Largest Holdings I’m starting the analysis by looking at the largest holdings in VDAIX. As you can guess from the name there is a heavy emphasis on receiving dividends from the portfolio. (click to enlarge) Where is the Oil? Granted oil prices are plummeting and oil stocks may seem “risky”, but a small inclusion would be entirely appropriate for a portfolio focused on dividends. The yields are high and the companies would benefit from higher gas prices while many parts of the economy would be disadvantaged by high fuel prices. For diversification purposes it is very strange not to have them included. Big oil can pay some big yields. ConocoPhillips (NYSE: COP ) has a dividend yield around 5.75%. When the mutual fund is yielding slightly over 2% it seems like adding some COP to the portfolio would be an excellent choice. It provides more diversification to the portfolio and a much stronger yield. Phillips 66 (NYSE: PSX ) is only yielding 2.6%, but that would still benefit the yield across the entire fund. Chevron (NYSE: CVX ) has a yield around 5%. Those all seem like viable options to me. If the portfolio is really focused on taking dividend income I would think COP and CVX would be a natural fit for the top 10 holdings. Diversification Benefits The correlation to SPY is just under 97%, so diversification benefits are not very substantial. However, the volatility on the fund is materially lower at only 87% of the level on SPY which is nice for investors that would prefer more stability in their portfolio values. Expense Ratio The mutual fund is posting an expense ratio of .20%. I want diversification, I want stability, and I don’t want to pay for them. An expense ratio of .20% may seem pretty good to many investors but this falls below my level expectations for Vanguard. Since Charles Schwab (NYSE: SCHW ) cut their expense ratios on ETFs and ensured the two were locked in a price war it has been easier for me to find very low expense ratios. With that said, .20% certainly isn’t bad. It just isn’t up to the level I want to see on my investments since I’m looking at the expected returns on periods greater than 30 years and the compounding effects of a high expense ratio can severely reduce an investor’s total wealth over a time period measured in decades. Sector Allocations To go a little deeper into the absence of the major oil companies I like to see included in a dividend growth portfolio, I grabbed a chart of the sector allocations. (click to enlarge) If you were to combine oil and gas with the utility sector the combined weight would still only be 3.5%. In my opinion the combined weight should be at least 20% and I wouldn’t object to seeing it even higher. Conclusion This is a pretty good fund but these investor class shares of the mutual fund carry an expense ratio of .2% which is higher than I would like to see. The bigger issue for many investors may be that the portfolio does not fulfill the reasonable level of diversification for the equity portion of a portfolio. If an investor wants to tie up a significant portion of their 401k account in VDAIX they would be wise to also hold funds that provide them with a material exposure to both utilities and oil and gas. For the sake of diversification, especially in a tax advantaged account, I would suggest including some equity REIT exposure to give the portfolio a more thoroughly diversified set of exposures while increasing the dividend yield since most equity REITs and utilities offer higher yields. Of course, using some CVX or COP is another solid way to boost yields even further. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

The Time To Hedge Is Now! 2 New Candidates To Add Before It’s Too Late

Summary The introduction contains a brief overview of the series. A couple of things to consider for those still on the fence and unhedged. A list of candidates including two new ones to consider. A discussion of the risk inherent to this hedging strategy relative to not being hedged. Back to Or Is IT Too Late? It is not too late to hedge, but doing it cheaply is getting harder. Most of my positions are working, but not all have shifted into gear yet. Some are not sporting gains as high as 1,200 percent. But this, as series followers know, could be just the beginning. 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. It may be more difficult to follow the logic without reading Parts I, II and IV. In 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 2014 update explains how I have rolled my positions. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. 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. If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term, you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but had also have eliminated the big losses. It makes a really big difference in the end. A note specifically to those who still think that I am trying to “time the market”, or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five-year period, I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more, I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point, the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. A couple of things to consider for those still on the fence and unhedged In my last update I mentioned the two things I am going to be watching on Monday morning are what happened in China equities and whether or not the price for WTI crude oil has held above $40 over the weekend. As I write this late Sunday evening, the Shanghai Index is down by over seven percent. That is not a good sign! I just checked the price of WTI crude oil and it currently stands at $39.37/bbl. This is also not a good sign. I may be wrong, but I suspect that U.S. equity markets will open lower on Monday once again. Chris Ciovacco does a weekly video that focuses mainly on technical analysis of U.S. equity markets. This last week was particularly interesting. He is very balanced in his approach, neither a bull nor a bear. He has a good set of rules that he strictly follows. It is well worth a few minutes to watch. Another eye opener is this article about falling container rates from Zero Hedge. This site tends to be mostly bearish but they do make some good points. I think this one is worth considering. A list of candidates including two new ones I will start with the two new candidates that I want to add for your consideration. I plan to try to add a small position in each as described below near the opening on Monday. First up is Masco (NYSE: MAS ), a manufacturer of home improvement and building supplies. I realize that the housing market has been humming lately and that is why this company has so far escaped the ravages of the last few days. As of Friday’s close, Masco was down only 7.2 percent from its 52-week high. If the U.S. economy falls into a recession MAS will catch up with the falling market and could potentially hit as low as $10. Back in 2011, the last time the U.S. economy barely kept from falling into a recession, MAS stock fell below $7. In a recession home building and improvements slow down as people either lose their jobs or postpone major purchases out of fear that they may lose their job. Masco Corp Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $26.53 $10.00 $25.00 $0.30 $0.40 3650 $4380 0.12% I will need to purchase three January put options with a strike of $25 to provide myself with the protection shown above. The next new candidate is Coca Cola Enterprises (NYSE: CCE ) another sleeper that has not been beaten down yet. The company sold all of its North American bottling operations to the Coca Cola Company (NYSE: KO ) in 2010. The current company has operations in Great Britain and much of continental Europe. When the next global recession hits, and it has already started in Europe for all practical purposes, it will be become increasingly difficult to maintain sales volume. That has already begun as sales in quarter one of 2015 were down 13 percent compared to the same period last year. Profits were down nine percent. Yet, the share price has held up nicely. I do not believe that will last as the pressure to cut prices in an effort to maintain volume will narrow the profit margins. CCE stock price on Friday closed at $51.79, only 3.7 percent off its 52-week high. I believe this is another issue that will play catch up once investors catch on. Coca Cola Enterprises Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $51.79 $24.00 $45.00 $0.65 $1.05 1900 $3,990 0.21% And now for the rest of the list. I will not go into detail on why I expect each candidate will fall as I have done so in past article at length. Readers who want to understand my reasoning better can find those details in the early parts to this series. Goodyear Tire & Rubber (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.28 $8.00 $22.00 $0.35 $0.50 2700 $4,050 0.150% I would need three January 2016 GT put option contracts to cover approximately one eighth of a $100,000 equity portfolio. If you already own a full position of GT options, do not exchange those for the new position. This would only add to your cost by increasing transactions. This new position is for anyone who has not yet completed their position or who may be rolling over to replace a July position. This statement applies to all of the “new” positions listed in this article. Do not trade in and out of positions to try to improve your overall position. That just defeats the purpose of keeping this strategy affordable. A better strategy is to average into a position over time, lowering your average cost basis with each purchase. Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $83.31 $24.00 $70.00 $1.35 $1.90 2321 $4,410 0.190% I need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Tempur Sealy International (NYSE: TPX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $74.51 $16.00 $60.00 $1.05 $1.70 2253 $3.830 0.170% I will need only one January 2016 TPX put options to complete this position for each $100,000 in portfolio value. Royal Caribbean Cruises (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $85.71 $22.00 $70.00 $1.78 $1.99 2312 $4,601 0.199% I need one January 2016 RCL put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $69.33 $30.00 $60 $1.55 $1.75 1614 $2,825 0.175% I need one January 2016 MAR put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. E*Trade Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $25.54 $7 $20.00 $0.60 $0.65 1900 $3.705 0.195% The position shown above would require three January 2016 ETFC put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $80.29 $30.00 $70.00 $1.95 $2.20 1741 $3.830 0.220% I need one January 2016 LB put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $34.21 $15.00 $28.00 $.61 $.71 1731 $3.687 0.213% I need Three January 2016 MS put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $59.58 $16.00 $55.00 $2.65 $3.10 1158 $3,590 0.310% I need one January 2016 KMX put contract to provide the indicated loss coverage for each $100,000 in portfolio value. Sotheby’s (NYSE: BID ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $35.90 $16.00 $30.00 $.85 $1.05 1233 $3.885 0.315% I need three January 2016 BID put contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Summary My eight favorite positions at this point include the two new candidates, MAS and CCE, along with BID, KMX, RCL, MAR, WSM and LB. The China problems should spill over into the BID stock performance soon. The remaining five are dependent upon a U.S. recession, which I now believe will be difficult to avoid. A discussion of the risk 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 risks 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. If the market somehow rights itself and the bull market continues into 2016, all of these positions could potentially expire worthless unless the stock price associated with specific puts is below the strike price. It is insurance against catastrophic loss, not a get rich quick scheme. There is a price to pay for insurance. Worst case we will likely be able to scalp some more gains from MU and possible one or two others when it comes time to roll positions if the bull regains its footing. If that happens I will establish new hedge positions with expirations out to January 2017. I could be wrong, but I really do not think we will need to wait that long for the hedge to work. 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: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I hold, or will purchase, put options on all the companies listed in this article.