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Back to Part II

In the first article of this series, I provided an overview of the strategy to protect an equity portfolio from heavy losses from a market crash of 30 percent or more. In Part II, I provided more explanation of how the strategy works and gave the first candidate company to use as part of a diversified basket using put option contracts. I also provided an explanation of the selection process and an example of how it can help grow both capital and income over the long term because it conserves capital during downturns without the need to sell your long-held equity positions. What I did not provide yet was a basic tutorial on options contracts, which I believe is necessary to make sure readers understand the basic mechanics and correct uses, as well as the risks involved when options are used speculation.

In this article, I will provide the options tutorial as well as some links for additional information that I believe can be very useful. I will also provide another candidate stock for use in this strategy.

I am not predicting a market crash. I want to make that clear. But bear markets are part of investing in equities and I find that taking some of the pain out of the downside helps make it easier to do the right things: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects; and then hold onto to those investments forever unless one of the fundamental reasons we bought them in the first place changes. Investing long term works! I just want to help make it work a little better and be a little less painful.

We are already past the average duration of all bull markets since 1929. Actually, by April of this year, the current bull market will have surpassed in length all but three bull markets during that time period (out of a total of 15). Thus, I have decided that it is time to start preparing for the inevitable next bear market. I intend to employ the strategy in four stages over the next few months which will allow me to average into the full position I intend to build. I do not know when the strategy will pay off, but experience tells me that we are probably within a year or two from needing to be protected. It is not fun to write about down markets, but the fact is: they happen. I don't mind losing five or ten percent or even 15 percent from time to time. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first and second articles of this series. Without that foundation, the rest of the articles in this series won't make much sense and could sound more like speculating with options. That is absolutely not my intention. With that stated, I will now proceed to explain the basics of options.

Options Basics for American style option contracts (there are also European style options which we are not using for this strategy)

There are two types of options: calls and puts. When an investor buys a call option contract s/he has the right, but is not obligated, to buy 100 shares of a specific stock at a predetermined price (the strike price) at any time before the option contract expiration date. When an investor buys a put option contract s/he obtains the right, but is not obligated, to sell 100 shares of a specific stock at a predetermined price (the strike price) at any time prior to the expiration date of the option contract.

When an investor sells an option (without having first purchased them) s/he is actually creating a security that did not exist before. This action is also called writing an option. When writing an option contract, the seller is giving the buyer the right to buy or sell 100 shares of the underlying stock at the strike price any time before the option contract expiration date. The buyer of an options contract must execute the option prior to expiration or the contract will expire worthless.

When someone sells (writes) a call they are agreeing to sell to the buyer of the contract 100 shares of the underlying stock any time prior to the option contract expiration date at the strike price, but only under two circumstances: if the buyer executes their rights under the option (the phrase used to describe this action is often referred to as "calling away the stock") or if the stock price is above the strike price on the expiration date. In the latter case, most brokerages will complete this transaction automatically. It is important to note at this point that I would never recommend selling/writing naked calls (meaning writing calls without owning the underlying stock) because of the level of risk which is associated with such a speculative position.

When someone sells (writes) a put they are agreeing to purchase from the buyer of the contract 100 shares of the underlying stock any time prior to the option contract expiration date at the strike price, but (once again) only if the buyer executes his/her rights under the option contract or if the price of the underlying stock is below the strike price on the expiration date. I actually do sell puts for specific purposes which has nothing to do with the strategy of this series. I have written extensively on this subject, so if someone would like to know more please leave a comment and I will provide a link or two.

The price of each option contract is called the premium and is listed as the price per share. Each standard option contract represents 100 shares. Thus, the full price paid or received by the buyer and seller of each contract is the price/premium multiplied by 100. Example: one put option contract on Applied Materials (NASDAQ:AMAT) with an expiration of January 2015 and a strike price of $15 has a premium (as of the close on February 7, 2014) of $0.94. Since the contract represents an option on 100 shares of AMAT, the actual price per contract is $94.00 ($0.94 x 100).

An option can be either "in the money" or "out of the money." A call option is considered "in the money" when the price of the underlying stock is above the strike price of the option. Conversely, a call option is considered "out of the money" when the price of the underlying stock is below the strike price of the option. A put option is considered "in the money" when the price of the underlying stock is below the strike price of the option. A put option is consider "out of the money" when the price of the underlying stock is above the strike price of the option.

Investopedia has a good article that explains the basics of options and also has a nice article that explains the components of an option price: intrinsic and extrinsic (time value) values. I suggest you read that article before beginning to implement this or any other options strategy. It is very useful information.

I need to stress that I use option only as part of a strategy. In this series I am explaining one way of using options to protect all or a portion of the value of an equity portfolio. I also use options to enhance my income from dividend paying stocks, to produce income on cash while I wait for a better entry point, to create synthetic stock positions to capture stock appreciation without actually owning the stock or to systematically lower my cost basis of long-term stock holdings. But I will stick to only the strategy of protecting your portfolio for this series. Options can be useful for those who take the time to understand the proper use of such tools.

The next candidate stock comes from the technology sector. Not all tech stocks get hammered during recessions, but many do; and some drop much more than others. Technology stocks generally carry much less debt, so those companies that carry significant debt often tend to be more volatile during economic downturns. Another reason that some tech stocks take a beating is that those companies are dependent upon corporations and governments to update technology periodically for sales. When a recession hits, many of those customers postpone investing in technology upgrades, especially on the hardware side, until the economy begins to improve. Thus, those tech companies that depend on those regular upgrades by such customers see revenues fall and margins contract, especially in the early stages of a recession; at least during the first year when all the layoffs (huge one-time costs), inventory write-downs (also temporary) and other cost cutting decisions are implemented to right-size operations to match the changed environment. Most of those efforts have significant costs associated with them and, combined with reduced sales and decreasing operating margins, take a toll on the bottom line. Then there is the always possible threat of obsolescence due to newer, competing technologies, especially for commodity products. High beta stocks abound in this sector. Once again it is really a matter of finding the weakest of those that tend to be the most cyclical in nature.

Hard drives for data storage is a commodity business now, but continues to have growth prospects due to the continuing surge in data creation and storage. However, it is also a very competitive industry where even the slightest advantage can lead to a significant swing in market share and revenue. Things have been relatively stable for a few years but a recent event has set the stage for change. More on that in a moment.

Seagate Technologies (NASDAQ:STX) was involved in a leveraged buyout in 2000 during which the software portion of the company was sold. The new company went public in 2003 at $12 and rose to $31.80 later that same year only to fall back to $10.10 in 2004. The company's stock then climbed up to $28.90 at the top in 2007 and fell during the Great Recession to a low of $3.00 in 2009. Value Line lists the beta on STX as 1.35 while Yahoo Finance reports a beta of 3.14. Yahoo's calculation is the more current and reflects the most recent sell off in the stock. The stock performed extremely well (until recently) since late 2011, jumping up from $9.00 to a recent high of $62.76 achieved this January. The stock is currently trading at $49.52 (as of the close on Friday, February 7, 2014).

Seagate has a debt-to-capital ratio of 43 percent which is high for the tech sector but it does have a strong cash position and has been paying down debt while also buying back shares. The dividend is currently $1.72 per share producing a yield of 3.3 percent. But the company cut its dividend in 2008 and then suspended the dividend in 2009 only to reinstate the dividend in 2010 at a higher level. The stock price reacted accordingly falling nearly 90 percent from the 2007 high to the low in 2009. Revenues fell, earnings turned into a loss, margins dropped, and capital investment fell. I see no reason to believe that results will improve in the next recession.

We have already had a little taste of what can happen to STX if the market turns lower. STX has fallen by 21 percent in less than a month! I attribute much of this negative activity to a recent study by Backblaze which I came across in this article on Seeking Alpha. Whether the U.S. economy sinks into another recession or not, I have a hunch that STX stock is likely to fall some more as customers decide to seek a more reliable alternative. I expect that, during a recession, STX stock could easily fall below $20 a share, especially when the additional impact of the negative study results are included into the forecast. STX is likely to be forced to lower its price in a commodity business to retain customers. Alternatively, the company could attempt to retain its pricing which I would expect to result in a loss of market share. Either way, STX margins are likely to take a beating and the bottom line will suffer.

The sweet spot in put options on STX, by my calculation, is January 2015 expiration contracts with a strike price of $30 and selling for a premium of $0.71 per share ( as of the close on Friday, February 7, 2014). However, since the shares are down the bid and ask prices on the contract are above the last trade price at $0.85 bid and $0.90 ask. Thus, I will use $0.90 for the example to remain conservative. Each contract represents an option to sell 100 shares and will cost $90 (plus commissions). If the share price falls to $20 or less by January 2015, the potential gain is $910 per contract, or just over 1000 percent.

If the price falls below $20 with several months left before expiration and we decided to unwind the hedge, we may not be able to capture 100 percent of the potential due to the extrinsic value (time value) that would remain. However, we would be able to capture most of the potential gain. Likewise, if the price falls below $30 but remains above $20 by the expiration date, we would only capture a portion of the potential gain. And it is always important to remember that if the price of the underlying STX stock remains above the $30 strike price through the expiration date, we may lose 100 percent of the amount invested in the options contracts as protection.

My feeling is that, due to the uncertainty of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, I would prefer to risk a small portion of my capital (perhaps five percent) to ensure that I hold onto the rest rather than risking losing a much larger portion of my capital (30 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. The ten percent rule can come into play when a bull market continues much longer than expected. And when the bull rages on longer than it should the bear that follows is usually deeper than it otherwise would have been. In other words, I would expect a much less violent bear market to occur if it begins in 2014; but if the bull can sustain itself well into 2015, I would expect the results of the next bear market to be more pronounced. If my assessment is correct, protecting a portfolio becomes even 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.

Source: Protecting Your Equity Portfolio For Less - Part III