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Retail investor, long/short equity, dividend investing, medium-term horizon
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It's a lot easier to play defense if you are prepared when the trouble starts. Back on April 1st I wrote a somewhat somber article entitled “Positioning for a Bumpy Ride.” It was less about calling future market trajectory than it was about being prepared, a laundry list of items to check and adjust in advance of market difficulties. I did much of what I planned and I'm pleased with how my portfolio responded to recent market conditions.

Defensive Strategy

A large part of my portfolio consists of options, primarily long positions taken by means of in the money LEAPS. To some extent this reflects the desire to use leverage, but another consideration is these positions, when held in a portfolio with adequate hedging and cash support, afford certain defensive advantages.

The key is, when markets nosedive, volatility increases. An investor who is willing to sell options close to the money, while spending or tying up cash, and accepting additional downside exposure when most market participants are trying to raise or conserve cash and avoid taking on more risk, can make surprisingly good returns, assuming the market eventually heads back up.

This becomes a series of clerical chores, checking the cost of rolling calls down, checking the premiums available for selling puts at the selected strike and expiration, making the trades, and monitoring the performance of hedges and availability of funds for the next move down.

The strategy amounts to a controlled retreat: at each barricade, as the enemy troops advance, a few volleys are fired, then the troops fall back to the next pre-planned defensive position. There is no doubling down, no goal line stands, just another round of small size options trades. Low price, high beta or illiquid stocks that were reduced when things were good can be brought back up to size.

Hedging

Hedging is done in advance. The more agile and adroit big-time players can turn on a dime as the market goes down, thereby insulating themselves from loss. Those who are not that quick on their feet (myself among them) will do better to ascertain how much hedging they need and arrange for it while volatility is low and prices are affordable. By 4/26/10 I had figured out the soft points and taken out adequate protection.

Over the past few months my thinking on hedging has changed: when last I ran a hedge, the plan was to insulate the portfolio from a market value loss of more than 10%. This proved expensive, and when volatility got high I succumbed to temptation and cashed in the hedge, at a nice profit, but too early, as it turned out.

I have now come around to the opinion that it is better to accept a certain amount of temporary loss of market value, while ensuring that funds and/or protection are available to implement the overall strategy discussed earlier.

An investor who believes the market will go down and not come back up has a far simpler task – he can liquidate and sit on the sidelines, or short it all the way to zero, if he is so inclined.

Multiple Hedges

My current approach relies on several different types of hedge.

The sale of covered calls hedges a moderate amount of downward movement, limited to the premiums received.

Long positions taken by means of in the money calls will gain time or extrinsic value as stock prices decline: they get closer to being at the money, and volatility increases. Rolling down harvests the time premium as a consolation for the hopefully temporary loss of portfolio value. This is a type of volatility hedge, preferable to trading VIX in that it is less crowded and responds to the individual stock situation.

The purchase of puts on indexes or ETFs is effective, particularly if done in advance while volatility is low and premiums are somewhat affordable. VIX under 20 would suggest prices are affordable, lower is better. If a portfolio has a disproportionate exposure to a given sector, the appropriate ETF can be used as a hedge. I prefer to accumulate a hedge over a period of time, using distant expirations and budgeting the expected losses out over the coming year.

For example, I own SPY December 2012 140 puts. These are deep in the money, and behave predictably as the market rises and falls. My expected case is that the S&P 500 will go to 1,400 by expiration, so the cost of the insurance can be figured pro-rata and held to 2% of my portfolio annually. The 2% was inspired by the amounts some financial advisors levy as a tax on their clients. These puts are constructive cash, and are intended to be liquidated as a source of dry powder at either a profit or a reduced loss at times of market turmoil.

As of this moment I also own XLF September 2010 14 puts and SPY July 2010 109 puts. These out of the money puts were selected after review in order to cover vulnerable options positions where there was a profit to protect and the premiums on the insurance were acceptable as a cost against the profits. The expirations selected are later than the expirations on the positions defended. Options positions become vulnerable to sudden price changes as expiration approaches and short-term hedging may be in order.

As the situation developed, I sold off about a third of the puts on Friday 5/7 when prices were high, enough to cover the entire premium expended and give me a substantial amount of free insurance. The rest will be retained until the positions they protect expire.

Playing My Natural Direction

All of the above is somewhat elaborate and detailed. Sometimes I ask myself why I don't just grab my mouse, short like crazy, and ride the market up and down. I read posts from time to time by people who seem to be able to trade that way.

I've tried that and it gives me a sick and disoriented feeling.

What I've come up with is the principle that I always trade consistent with my long-term directional opinion. If I think a market, sector, or stock is undervalued I will be net long. By nature I'm an optimist, never very successful at shorting, so my basic position is long. It's like being a pull hitter in baseball: it would be nice if I could hit to the opposite field, others do it successfully, but I don't.

An exception would be where an existing options position develops problems and the duration or extent of the damage is unclear. If bad news comes up overnight, the investor can wind up sitting there watching it get hammered in the pre-market and options aren't trading yet. Or sometimes it's painfully obvious what Mr. Market's opinion for the day is. In that case, I figure out how many shares I need to sell short in order to go delta neutral and I take myself out of the position until I can absorb the new information and make a decision.

Aside from that, I play my natural direction.

Buying Back Options

At market high points, I've made a habit of buying back any puts where more than 80% of the premium has been earned. Selling puts is always subject to the criticism that it's like picking up nickels in front of a bulldozer. For that last nickel or dime, the exposure to unexpected consequences if the market hits an air pocket isn't worth it.

The case on nickel and dime covered calls that may be out there is less clear, but lately I have been applying the 80% rule there too. On Friday 5/14 I bought back a few calls.

My impression without doing a study is that the options can be resold after the market reverses direction, at a sufficient premium to cover trading costs for the activity over any protracted period of time, so this becomes a housekeeping chore that avoids the occasional disruption. I once had a bunch of nickel calls I was short go pretty deep in the money on expiration day. I watched in total aggravation and finally closed the position at a sizable loss. I am not going to talk about where the stock closed for the day.

Down Friday: ? Monday

A post by Bespoke Investment Group about the trend for Monday through Wednesday to be up and Thursday and Friday down got me thinking about an article I once read in the Trader's Almanac. The gist of it was that if there is a combination of a badly down Friday confirmed by a badly down Monday subsequent market direction is down and painfully so.

Writing this on a Sunday, I don't have an opinion about Monday's market direction. But I do have a list of things I might do if it continues downward.

Disclosure: Author is short SPY and XLF as discussed and has no position in VIX

Source: Future Market Trajectory: Playing Defense