The Time To Hedge Is Now! November 2015 Update – Part II
Summary Brief overview of the series. Why I hedge. What to do with open positions expiring in January 2016. List of favorite candidates to consider now. Discussion of the risks inherent to this strategy versus not being hedged. Back to November Update Strategy Overview I could not include all the moves and results that I wanted to in the original November Update article due to length, so I am continuing with Part II. For new readers I have not changed the overview or why I hedge sections, so returnees from Part I can skip through those sections to save time. 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 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 sizable market correction. 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. Why I Hedge 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 have also have eliminated the big losses. It makes a significantly positive 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. What to do with Open Positions I want to start out by listing the remaining open positions that will expire in January 2016 and continue to retain some value of more than $0.10 to cover commissions should one consider selling. I will state here that I intend to hold all positions that are below that value as it makes more sense to let them expire worthless than to spend money to close positions. Those contracts that expire worthless, as in the past, are simply the cost of insuring a portfolio against potential loss. Insurance is never free. If the market takes a dive we can come back to reassess those positions if there is value created before expiration. The ask premium listed in the tables below is from when I recommended the purchase. The bid premiums listed are the current premiums available. Investors should do better than the listed prices on both ends but I prefer to use “worst case” examples to make things more believable. First off, I included CarMax (NYSE: KMX ) as it has some positions with value still remaining. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $55 $1.85 $2.10 $25 13% May $55 $1.40 $2.10 $70 50% June $57.50 $1.80 $3.20 $140 78% August $55 $3.10 $2.10 -$100 -32% September $50 $1.80 $0.75 -$1.05 -58% I intend to hold onto any of the positions I have in KMX and add contracts with future expirations when the cost is more in line with my strategy guidelines. I did add a position in KMX in October with some April put options with a strike at $40 which are under water and I intend to hold those as a fill position as I wait for better premiums and open interest/volumes on contracts that expire later. Next, we have Marriott International (NASDAQ: MAR ) which has a few contracts that still retain value. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $55 $0.80 $0.15 -$65 -81% June $65 $1.75 $1.05 -$70 -40% August $62.50 $1.45 $0.70 -$75 -52% August $60 $1.75 $0.50 -$125 -71% September $62.50 $1.75 $0.70 -$105 -60% I will continue to hold all MAR positions until I have the opportunity to replace the protection with more favorable entry positions with expirations further out. I did add some April MAR put options in October with a strike of $65 which are currently trading at about $2.25 where I originally bought them. I will hold this position. I only have two open positions in Veeco Instruments (NASDAQ: VECO ). Month of purchase Strike Price Ask Premium at purchase Current Last Premium $ Gain Available per contract Percent Gain Available May $20 $0.90 $1.40 $50 55% June $20 $0.40 $1.40 $100 250% I will continue to hold VECO put options as this stock has already fallen from the mid-30 dollar range when I first identified it as a candidate last April to the current price of $19.77 (as of the close on Wednesday, November 18, 2015). There may still be some more gain to capture before the January 2016 expiration. However, these shares have already fallen so much that the strategy will no longer work well for adding new positions in the future. I still hold several positions in L Brands (NYSE: LB ) put options dating back to December. There are six positions listed in previous articles that still have a value of over $0.10. All positions in LB currently show losses. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $65.50 $1.10 $0.15 -$95 -86% May $70.50 $1.85 $0.25 -$160 -86% June $72 $1.45 $0.30 -$115 -79% August $70.50 $1.50 $0.25 -$125 -83% August $70.50 $2.20 $0.25 -$195 -87% September $78 $1.80 $0.70 -$85 -47% I intend to continue holding all open positions I have in LB. LB has some premium brands that may suffer during a recession. That is why I believe the stock fared so poorly in the last two recessions. I will continue to use LB in the future. Morgan Stanley (NYSE: MS ) has had mixed results, mostly losses, so far. I have five open January put option positions in MS from previous articles with values above $0.10. I do not own all recommended contracts, but do own some contracts of each candidate listed in my articles. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available May $28 $0.44 $0.15 -$29 -70% June $34 $0.92 $1.27 $35 38% August $35 $0.96 $1.72 $76 79% August $28 $0.71 $0.15 -$56 -79% September $27 $0.62 $0.10 -$52 -84% I also hold an open position from October in the April 2016 MS put options with a strike of $25. I intend to hold all positions in MS and add more in the future. Level 3 Communications (NYSE: LVLT ) was down over 21 percent in August while the S&P 500 fell about ten percent. This is an example of what can happen to the candidates I use. I only have one open position in LVLT with a value remaining of over $0.10. This is another example of the volatility of this stock. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available June $42 $0.90 $0.15 -$75 -83% The LVLT position could be positive again with another market swoon. I will continue to hold my positions in LVLT and intend to continue to use it in the future. The only concern I have with this one is the lack of active trading in the options. I only list a contract that has open interest of more than 50 contracts and prefer more than 100. Many of the LVLT contracts have too few contracts open to consider. Tempur Sealy (NYSE: TPX ) share price continues to surge to near record levels. This is actually good for us in terms of future hedging. I have only three open positions with a remaining value above $0.10. The last price these options traded at is $0.50 but the last bid listed was at $0.25. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $60 $1.50 $0.25 -$125 -83% August $60 $1.70 $0.25 -$145 -85% September $60 $1.60 $0.25 -$135 -74% Again, this issue is likely to fall precipitously again when a recession occurs. I will hold my remaining positions and continue to use TPX in the hedging strategy. Royal Caribbean Cruise Lines (NYSE: RCL ) shares have continued to rise and are within about six percent of the high. I have not fared well with these positions yet, but when a recession hits this stock has a tendency to fall fast as consumers put vacation plans on hold or shop for deep discounts. Either one hurts RCL margins. I have only two open positions in January options for RCL that remain above $0.10. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $72.50 $1.65 $0.24 -$141 -85% August $70 $1.99 $0.18 -181 -91% I will continue to hold my RCL positions and add more in the future. This is insurance. I remain convinced that RCL will pay off big when we really need it. Coca-Cola Enterprises (NYSE: CCE ) initially fell right after I bought my first position. It had also fallen in previous short-term market corrections by much more than the overall indices. I have only one January option position in CCE open that is valued over $0.10. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $45 $1.06 $0.15 -$91 -86% I will hold my CCE positions and add more when the premiums are low enough on future contracts. United Continental (NYSE: UAL ) is one of the weakest remaining major airlines. Its rival, American (NASDAQ: AAL ), is also one to consider if you consider it as a better proxy. Make no mistake that these shares should plummet when a recession hits regardless of the cost of fuel. The shares have been struggling even with low fuel prices. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available September $45 $1.39 $0.31 -$108 -78% I intend to hold my UAL positions and add more in the future. That concludes the summary of outstanding positions expiring in January and what I intend to do with each. List of favorite candidates I listed five candidates with my favorite option contract for each in Part I. E*TRADE Financial (NASDAQ: ETFC ), Goodyear Tire (NASDAQ: GT ), Morgan Stanley , and Royal Caribbean Cruise Lines all have slightly lower premiums available as of the close on Wednesday, November 18, 2015. A couple more day like yesterday and everything will be cheaper. Patience is always a key factor in investing. I start with a new candidate to get things rolling. Boyd Gaming has shown the propensity to fall faster than the overall market, not just in major crashes, but during the brief market declines as well. The share price fell significantly more than the rest of the market during the scares of 2011, 2013 and 2014. It was decimated during 2008-09. It is currently less than three percent off its high of the year and represents a good opportunity for entering a position on this upswing. Another recession could take this issue all the way back down to $5.00 per share. Boyd Gaming (NYSE: BYD ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $20.57 $5.00 $17.00 $0.40 $0.60 1,900 $3,420 0.18% I need three BYD March 2016 put option contracts to provide the indicated protection for a $100,000 portfolio. Masco Corporation (NYSE: MAS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.84 $15.00 $23.00 $0.20 $0.45 1,678 $3,775 0.225% MAS hit a new 52-week high on Wednesday. Its fortunes are highly correlated with construction and home improvements. A recession could clobber this business. I need five April 2016 put contracts as described above to provide the indicated protection for a $100,000 portfolio. Those are the only new candidates I want to add at this time. As I mentioned earlier in the article, I am hoping to find some more candidates and better entry prices in the future. I will be submitting articles each time I find something worth sharing. Summary As I pointed out in the article linked at the beginning of the precious article I believe that the market is at a crossroads. There is very little impetus to drive prices higher other than cheap money, but cheap money may be enough to keep things going a little longer. If a bear market does not show itself before January 2017 I will be surprised. Many stocks are already experiencing a “stealth” bear market and therefore I believe it is prudent to make prudent hedging decision for 2016. I would like to extend the expirations on contracts more than I have for more extended coverage but the open interest/volume is not yet high enough to wade into those contracts. That should change over the next few months and I will be ready to add more positions as it happens. That is one of the primary reasons why I have tried to emphasize that I am only adding partial positions at this time. That is also why I intend to hold current positions as a means of maintaining protection while we transition to new positions. Going forward I want to write more often about this strategy for two reasons. The first is simply that is seems the global economy is nearly ready to fall into a recession and growth in the U.S. also seems rather stagnant. If profits continue to fall year/year as happened in the third quarter it may portend the beginning of the next recession. Retail sales and profit margins may prove to be the most important measure of the health of the consumer and, by extension, the U.S. economy. The second reason is that I would like to publish whenever I see a good entry point in one of the candidates or when I identify another candidate immediately instead of waiting for a monthly update. I hope these changes will be beneficial to readers following the series. 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 may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our old January expiration option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. 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. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market the more the insurance is likely to 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 two 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 three 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, at this point I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible but 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.
