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 detailed 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 selling your long-held equity positions. In Part III I provided 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 using options.
In this and the remaining articles in this series I will provide a short summary of the strategy and my first round of option positions that I either have or will have purchased by the end of the current week. I will also explain my reasoning as to why I chose the candidates for this purchase. So, in future articles those who are reading the complete series could skip over the summary portion because that will tend to be redundant for them. I am providing the overview primarily for the benefit of readers who are new to this series. However, if you are new to the series and like what you read here I strongly recommend going back to the beginning to get the full picture when you have finished this article.
First, I want to reiterate that 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. History teaches us that bear markets are inevitable. Those who believe that the market will just continue higher without ever correcting more than 15 percent again are in a state of dreamy denial. That is not to say that a bear market is imminent. No one knows with any great certainty when the next downturn will occur. But the fact is that we are closer to the beginning of a bear market now than we were a year ago.
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 this hedge 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 needed to be protected. It is not fun to write about down markets, but the fact is: they happen. I don't mind sustaining a setback of 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 three articles of this series. Without that foundation, the rest of the articles in this series won't make as much sense and could sound more like speculating with options. That is absolutely not my intention.
A Short Summary
The strategy is simply based upon the expectation that the weaker companies in those industries which are generally more adversely affected by economic contractions will fall further than the market averages. We use this expectation, along with the power of leverage and limited risk provided by options to construct a hedge position designed to protect as much of a diversified equity portfolio as an investor wishes. I suspect that the strategy is best explained by a hypothetical example. For that, I will use an abbreviated version of the example provided in Part II.
If the equity position of your portfolio had been about $500,000 in January of 2000 and you were invested in the S&P 500 Index, at the low point in 2002 the value of your portfolio would have dropped to approximately $255,000. Yes, the buy-and-hold investors would eventually see their portfolio value increase again to levels above the original $500,000, especially if they reinvested dividends. What we are trying to do with this strategy is to reduce that temporary setback from $230,000 to something less than $100,000 (the smaller the better). The difference of saving over $100,000 in principle can add significantly to a portfolio's growth over the longer term. We give up some of the income/appreciation near the top of the bull, but save the majority of our capital from loss to continue building our portfolio without having to dig out of those huge holes.
To take that example a little further, let us assume that you are using the dividends in retirement and unable to reinvest the earnings. Let us also assume that you are no longer saving from other sources and cannot add additional capital to your portfolio to increase your investments. So, now all we are measuring is the capital appreciation of your portfolio. If your portfolio value had been $500,000 in January of 2000 at the top and $255,000 in October of 2002 at the bottom, your portfolio would have climbed its way back up to $520,000 by July of 2007. Then it would have dropped back down to roughly $220,000 by early March of 2009. Today, the value of your portfolio would be back up to about $580,000. Assuming your stocks pay a rising stream of dividends you would be doing just fine.
If the same investor had used the strategy outlined in this series of articles, but would have only achieved a 50 percent hedge against those huge losses the outcome would have been drastically different. Today, instead of having about $580,000, you would have approximately $1,200,000 in your portfolio. The difference is staggering at $640,000! That is more than double the asset accumulation over a period of less than 15 years. For a more detailed explanation of how these results are calculated please refer back to Part II.
You may achieve better results than in the example or you may achieve poorer results than in the example. The point here is not how to get rich; it is merely a strategy to reduce your losses to enable you to keep your portfolio working harder for you. Now, I want us to look at the income side of the equation. In reality, your portfolio of equities will fall by the full amount of the market loss. But the options contracts will increase in value to offset a portion of those losses. Your income remains nearly the same from your original portfolio (minus the 5% each time used in the protection strategy). But, when you unwind your hedge positions you sell the option contracts for a gain. Assuming you simply add more of the shares that you originally owned so the yield does not change your income would now have increased by about 110 percent from what it would have been using a straight buy-and-hold strategy.
I hope that explains better the why of considering this strategy. A good article by another SA author about a couple of reasons why the market may falter soon can be found here. It is a well-reasoned article, especially in the second half where the author discusses catalysts that could cause a market correction. The author is a portfolio manager which, to me, means that he needs to remain relatively positive in order to support the sales of fund shares. Thus, he predicts a muted correction in the range of 15-20%. The article debunks the idea that we are heading into a repeat of 1929. I suspect, on that point he may be right, but that reality will fall somewhere in between the results of the Great Depression and his prediction.
Now we will take a look at my first round of put options that I am buying this week and why.
I will start by addressing my decision to not use ETFs as candidates since this question came up in the comments section several times in different articles. I took a look at many of the ETFs that represent cyclical industries. Most of those ETFs have not been in existence long enough to adequately analyze the degree of protection that could be expected during a recession. Many ETFs were created since the Great Recession. Very few of those that remain have options available with long enough duration to fit my strategy. As for the index ETFs, I do not use them for this strategy because, while such ETFs do provide a relatively good match for a diversified portfolio, the indexes represented by these ETFs include all of the best companies as well as the average and worst companies. That means that our potential downside is diluted by all the great companies that will tend to fall less than the weaker companies. This translates into higher premiums for less coverage in the case of a major downturn in stocks. When I hedge my portfolio, I like to do so without committing too much of my capital to the hedge. Using index ETFs does not meet my criteria. It is just plain too expensive for me. Remember, I do not know when or even if equities will tumble within the next year. That means the cost of the hedge may be totally lost if the market churns higher right on through January of 2015. Therefore, I want to minimize the expense of placing the hedge while maximizing the protection of loss to my portfolio.
This week I am adding either a half or a whole position of each of the six candidates I will list in this article. In the end, I will hold a full position of each candidate I listed in this series unless something drastically changes between now and my last purchase to change my mind. That means I will eventually hold put option contracts on all 17 of underlying stocks I reviewed (including both ETFC and MS). I do not believe that everyone should follow suit. Eight should be enough diversification to protect a portfolio. I am buying all 17 only because I think that I (and other authors) should follow their own recommendations to the extent they are able. I am eating my own dog food, so to speak.
I could have chosen just four and bought a full position of each to keep the transaction costs to a minimum. However, since I will be buying multiple contracts for each position the additional cost overall will be less than $100 total and I can live with that.
One of my readers pointed out to me that I might want to consider using technical analysis to determine my entry point for each position. I like using simple moving average (NYSE:SMA) crossovers for some decisions such as when to start removing my hedge positions or when to start building new positions after a bear market. In such instances I am looking at the SMAs for an index like the S&P 500. But I rarely rely on this indicator for sell or hedge decisions. But he did make a good point, so I did the analysis to see if it made sense. The answer is: only in some instances and more often than not we would miss a significant portion of the downturn making the hedge less effective. I ended up about where I started. But it was a good exercise.
The companies that I want to buy put options on first are the ones for which the stocks dropped the most in price in the early stages of the last two recessions and are signaling more technical weakness. Those six companies are: L Brands (NYSE:LB), CarMax (NYSE:KMX), Sotheby's (NYSE:BID), Jabil Circuit (NYSE:JBL), Morgan Stanley (NYSE:MS), and Williams-Sonoma (NYSE:WSM). All six of these companies have either experienced a crossover of the 50-day SMA to below the 100-day SMA or appear on the verge of it happening. All six of these companies' stocks dropped rapidly in the early stages of the last two recessions. As I have stated before, I believe that the market is likely to head even higher in the short term, but I do not know how high or for how long the current bull will continue. This means I may be early with some of my hedging, but since the costs are already very low I want to have my hedge mostly in place before the next bear begins. Once stocks begin to move lower in a sustained manner the premiums on put options will begin to rise adding more cost to our hedging strategy. That is something I want to avoid, if possible. Again, I cannot time the market; I just want to protect my gains from devastation if a significant downturn takes us by surprise. This bull is getting long in the tooth and caution is the key to holding onto that which we have accumulated.
I will list the ask price as of the close of the market on Tuesday, February 4, 2014 as the reference for future analysis. If the market goes higher over the remainder of the week I could get better prices. I will also place limit orders, depending upon the spread between the bid and ask premiums listed as well as the last trade listed. But to make things fair, I want to list the current ask price as the reference price paid since that is likely the worst we should get if the underlying stocks go higher from here. If the opposite happens and the selected stocks fall resulting in rising premiums I will write another article with the actual prices I ended up paying. Either way, I would prefer to use the worse reference price to remain conservative.
In the following table I have listed the current price of the stock, the expiration date, strike price and the premium for each option, as well as the number of contract I am buying for each $100,000 of my portfolio and the percentage of the position (50% or 100%) that those contracts represents. I will be buying multiples of the number of contracts listed to accommodate coverage of my full portfolio. The explanation of how to convert the number of contracts you will need is explained for one of the positions below the table. From that you should be able to calculate the conversion to hedge your own portfolio. Even though I am buying a position in all 17 candidates the contracts listed will assume eight positions total. If you decide to use this strategy, please make sure you are choosing to use the candidates that you prefer for your own reasons and use eight positions. Adjust the number of contracts you use for each position to "fit" your portfolio.
# of Contracts
Size of Position
Here is the calculation for the number of contracts needed of MS for a 50 percent position. Assuming a $100,000 portfolio, if we want to protect ourselves from a potential 30 percent loss of capital we need to create a hedge that will provide a gain to offset a potential $30,000 loss. We divide the $30,000 into eight nearly equal parts (positions) and use each of the candidate options chosen (eight out of 16) to provide protection for 12.5 percent of the $30,000, or $3,750. Then we determine the number of contracts it would take to provide a gain of approximately $3,750. In this case we need eight contracts for a full position; but since I am purchasing only half of my position at this time I need only four contracts. I will buy the other four at a later time. The cost is $72 (plus commissions) to protect slightly more than the required $3,750. That amounts to only 0.07 of one percent of the portfolio for this one half position.
The total cost of all six positions listed in the table above is $832 (plus commissions) to hedge against a loss of approximately $19,768 of a $100,000 portfolio, or almost 66 percent of a 30 percent drop in portfolio value. At this rate we could protect a $100,000 equity portfolio against a 30 percent loss with just over $1,200 (plus commissions). That amounts to just over a 1.2 percent cost to hedge. If the bull market continues we will be able to roll our positions for up to three years for a cost of under five percent of our portfolio. Five percent to protect against a 30 percent loss or more seems like a good deal to me.
To adjust the number of contracts to fit your portfolio size, simply divide your portfolio value by 100,000. Then multiply that result by the number of contracts needed for a $100,000 portfolio. If you have a $400,000 portfolio, you need 32 contracts for a full position of MS options (400,000 / 100,000 = 4; 4 x 8 = 32). To adjust the number of contracts in order to reduce the percentage of your portfolio that you want to protect, simply multiply the number of contracts needed to protect 100 percent of your portfolio by the percentage of protection you desire. Let us assume that you have a $400,000 portfolio and only want to hedge against 50 percent of a potential loss. All you do is multiply the 32 contracts calculated above by .5 and you find that you need to buy either 16 contracts. This tactic can reduce the cost to fit your budget in case you just can't afford to give up any of the income or don't have enough cash available to do more. Some protection can be better than no protection.
Now I would like to explain some things about the individual positions I am taking. First, I am waiting for an explanation on the BID options contracts from someone I expect to know the answer. In case you missed it, there are two nearly identical put options listed for expiration in January 2015 and strikes of $30. If I can I will purchase the options with the lower premiums, assuming the math still works out in my favor to do so. I will explain the outcome of that situation once I am comfortable that I have the information correct. Second, you may notice that a half position of three contracts in JBL does not provide as much coverage as the half position in MS. That is because JBL is one of the more expensive positions relative to the cost of coverage. The return is better on the MS position. I also rounded up the number of contracts on KMX because the potential return is much higher on that position.
My feeling is that, due to the uncertainty of how much longer this bull market can be sustained and the potential risk versus the potential reward of hedging versus not hedging, I would prefer to risk a small portion of my capital (perhaps up to five percent) to ensure that I hold onto the rest rather than risking losing a much larger portion of my capital (30 percent or more). 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 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.
I also want to stress that this strategy, as with any options strategy, contains risk of loss. Since we are buying put option contracts the loss is limited to the initial premium cost of the options contracts (plus commissions). However, the beauty of this strategy is that it only requires one of the multiple positions taken to work to cover the entire cost of all the options contracts purchased, including the commissions. If more than one position meets my expectations we begin to benefit from additional gains, thereby protecting a portion of our portfolio. If there is no recession, then it is very possible that none of the positions will meet our expectations and that we will lose all of the money invested in this strategy. Conversely, since we are trying to choose some of the weakest players in each industry, there is always the possibility that it won't require a recession for one of these companies to stumble. Remember, it only takes one to work in order to cover our costs. That is also why I suggest that to properly employ the strategy we need to initiate at least eight positions in eight different companies' stocks. That also provides a more diversified approach so we don't miss better results because we focused our hedge too narrowly if a recession does hit.
It is my hope that readers have found this article to be useful. 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 have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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 intend to buy the put option positions outlined in this article within the next 72 hours.