The Time To Hedge Is Now! January 2015 Update
Summary Brief overview and links to earlier articles in the series. Why Buy-and-hold investors should consider hedging. Sell your January 2014 puts in Terex (TEX) before expiration this Friday and lock in profits. Improved buy prices on select candidates. Discussion of the risks inherent to this strategy versus not being hedged. Back to December Update – Part II 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 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 Update (linked at the top of this article) explains how I intend to roll 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 turning 70 months now, 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. Sell TEX January 2015 puts now! I don’t like to hold short positions, especially on dividend paying stocks. Even though the dividend is tiny on TEX, I recommend selling the puts now. I sold two of my TEX put positions yesterday ($26 and $27 strikes) and am happy with my returns (680% and 809%, respectively). I also sold the last batch today ($23 strike) for a small profit. The bull market churned ever higher while we remained hedged and one of our candidates fell enough to help offset part of the cost of the hedge. I hope you held TEX puts in your hedge! Overall the hedge position (all 18 positions) lost money. All in all, because of the one good outcome my portfolio was hedged for most of last year for less than one percent. I estimate that this next year may cost over 1.5 percent of our total portfolio (I pay for mine by giving up a portion of my dividend income) if we buy all the puts today. However, there are some events coming up soon that could spur U.S. equities higher in the short term, depending on the outcomes. Pending Economic Events The biggest two events that are on the schedule, in my view are the European Central Bank [ECB] decision to increase quantitative easing coming on January 22 and the Greek election set for January 25, just three days later. I want to thank Mercy Jimenez for reminding me of these two important dates coming in the third week of this month. The ECB decision could provide a boost, if QE is initiated and is large enough to matter, to U.S. equities via the carry trade. Those with access to very low cost money in the Euro Zone will borrow cheaply there and reinvest where they expect high and safer returns; that would be the U.S as investors continue their flight to perceived safety). Both U.S. bonds and equities stand to benefit if the vote is positive. Currently, the plan does not seem settled as to the total amount of QE that the ECB will provide. Most recently I have read articles stating that 500 billion euros (just under $600 billion U.S.) is likely. However, a few days ago I read that the ECB was planning a one trillion euro (almost $1.2 trillion U.S.). I suspect the lower amount is more likely. On the other hand, if the measure does not pass, there could be a negative reaction as those who had positioned investments to take advantage of an expected run up would probably unwind those positions. The Greek election outcome appears to favor the Syriza party which is anti-bailout and wants to renegotiate the austerity terms required for more loans. If the Syriza party prevails and negotiations stall, it could bring the sovereign debt question in Europe back to the forefront. That could either hurt or help U.S. equities, depending upon how the outcome and its consequences are interpreted. If both votes go sour, then we want to be hedged because all bad news from Europe could cause enough fear in the global investors to go to cash. U.S. bonds would probably find support, but a risk off environment would likely result in a correction to equities. Being partially hedged at this point is a good bet. If the vote on QE by the ECB passes, we could get a good opportunity to buy more puts at lower premiums in the near future. Patience is the key. 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 Wednesday, January 14, 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 the “Last Premium” amount shown. This was the last premium paid on the last transaction of the day and provides a more accurate example of the cost and potential for each trade. 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. 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. 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 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 $25.43 $8.00 $15.00 $0.10 $0.65 $0.26 2592 $4,044 0.16% GT stock is actually slightly lower than it was at the time of the last update. But the potential gain is better if you can get in near the latest premium paid. Truck and SUV sales in the U.S. are improving due to lower gas prices, but sales of sedans and economy autos are dropping. Total sales for autos should be relatively flat with profits rising from a higher margin mix. But volume is likely to fall and that spells reduced sales for tire companies like GT. 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 contract, but the cost drops significantly to cover one eighth of a $100,000 equity portfolio. Seagate Technology (NASDAQ: STX ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $64.59 $24.00 $45.00 $0.53 $0.57 $0.54 3789 $4,092 0.11% We will need a total of two June 2015 STX put options with a strike of $45 to complete this position at current pricing levels for each $100,000 in portfolio value. The actual last premium was listed as $0.47 which is below the bid premium. That is not likely to happen, so I split the difference between the bid and ask price to get $0.54 and used that for the calculations. The cost per month is considerably lower using June options than using January 2016 options. CarMax (NYSE: KMX ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $63.42 $16.00 $35.00 $0.45 $0.65 $0.60 3067 $3,680 0.12% We will need two January 2016 KMX put options with a strike of $35 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 Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $81.94 $22.00 $57.50 $0.85 $0.96 $0.91 3801 $3,459 0.09% We need only one June 2015 RCL put option contract to fill this position and protect against approximately $3,459 in loss on a $100,000 portfolio. United Continental Holdings (NYSE: UAL ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $64.05 $18.00 $35.00 $0.29 $0.64 $0.46 3596 $3,308 0.09% We need two June 2015 UAL put option contracts to fill this position and protect against approximately $3,308 in loss on a $100,000 portfolio. Currently the June contracts are more cost effective than the January 2015 contracts. L Brands (NYSE: LB ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $82.12 $20.00 $50.00 $0.80 $1.00 $0.85 3429 $5,830 0.17% We need two January 2016 LB put options 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 have increased the strike price from $40 to $50 here resulting in a significant rise in the amount hedged. Marriott International (NASDAQ: MAR ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $76.57 $30.00 $50.00 $1.00 $1.20 $0.95 1718 $3,780 0.22% We need two January 2016 MAR put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Since the last premium was below the bid I chose to split the difference between the bid and ask premium and used $1.10 as the premium for the calculations. Micron Technology (NASDAQ: MU ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $30.05 $10.00 $17.00 $0.53 $0.59 $0.55 1173 $3,870 0.33% We need six January 2016 MU put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. The cost of these contracts is coming down slowly because the stock price has fallen since the last update. I will probably not add much, if any, of this candidate to my hedge unless I can get a better premium in the future Williams-Sonoma (NYSE: WSM ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $76.99 $20.00 $55.00 $1.40 $1.90 $1.43 2348 $3,357 0.14% We need only one January 2016 WSM put option contract to provide the indicated loss coverage for each $100,000 in portfolio value. In the last update article I used May options. Since then the pricing in the January contracts has become more favorable. Level 3 Communications (NYSE: LVLT ) Current Price Target Price Strike Price Bid Premium Ask Premium Last Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $47.88 $15.00 $40.00 $1.15 $1.35 $1.20 1983 $4,760 0.24% The position shown above would require two June 2015 LVLT put option contracts to provide the indicated loss coverage for each $100,000 in portfolio value. Remember that these options expire in June 2015 and will require us to replace them at additional cost. Even though the cost has come down by almost a third, I do not intend to add LVLT contracts at this time. I will wait for better pricing or use another candidate for my hedge. Morgan Stanley (NYSE: MS ) and Sotheby’s (NYSE: BID ) option costs are still too high to be considered at this time. I plan to wait for better entry points before adding to my hedge position with these candidates. Summary My top eight choices from the list above includes LB, KMX, GT, WSM, MAR, RCL, STX and UAL. That group (using the put option contracts suggested above) should provide approximately $31,550 in downside protection against a 30 percent market correction at a cost of 1.1 percent of a $100,000 portfolio. Granted, four of the candidates will need to be replaced by May or June which will add to the total cost, but we should still be able to keep the total hedge cost below two percent for the 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. Additional disclosure: I hold put option positions in each of the stocks listed in the article.
