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Summary

  • The article introduction contains a brief overview of the series, links to more detailed explanations and why I think that now is the time to begin the hedging process.
  • A brief summary explanation of the strategy and its low cost benefits is provided for readers who are new to this series.
  • The step by step process that I use to implement this strategy is explained in detail, including spreadsheet examples and formulas.
  • The article concludes with a discussion of the risks of employing this strategy versus not being hedged.

Back to Part XII

I want to begin this article a little differently, but just this once. Since I have received several requests from readers to provide a more detailed explanation of how I choose the specific option contracts that I like, I have chosen to devote the "meat" of this article to that subject. I do so in order to facilitate the use of stocks of companies that were not included on my list provided within the series. I have provided my favorites, but others may have found candidates that could work even better. Thus, the mechanics of the selection process of stock selecting gives way in this article to the selection process for identifying the best option contract offered once the stock is selected.

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 either an update on the option positions that I either have or will have purchased or another purpose relating directly to this strategy. I will use this particular article to answer a question that has come up multiple times in comments and private messages: How do I identify the option contract(s) that I like best for a particular stock. I will go through my process step by step and provide the simple formulas that I use in an Excel spreadsheet to find what I determine to be the best fit. 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.

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 on 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. 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. 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% or less 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.

Now I want to explain how I select the contracts that I expect to benefit us the most. After selecting the stocks you want to use, either from the 12 provided in previous articles of this series or others that you have found with the necessary attributes that you like better, you must decide which option contract is most likely to provide the most hedge protection at the lowest cost. This is a multiple step process.

Step one is to determine an approximation of what I expect to be a good strike price based upon the difference between the option strike and the target price. I want the difference to be roughly ten times the premium. I find examples work best in an explanation like this so I will provide one at the end of this section that will walk you through the full process one step at a time. In the example below, I am using the first candidate of the series from the second article, United Continental (NYSE:UAL).

The second step is to determine the best contract expiration month. I use the strike price determined in step one and compare premiums between the available expirations (in this case January 2015 and January 2016). In the series thus far I have chosen all contracts that expire in January 2015. There are reasons for this selection. First, when I compare similar strike prices for put options expiring further out (January 2016) I look to see if the 2016 contract has a premium that is close to double the cost of the 2015 contract at the same strike price. As time goes on, though, there will be more emphasis on selecting contracts that expire further into the future. The purpose of this step is to keep the costs low. If a bear market were to begin this year the 2015 contracts should be the best place to be. If the market keeps churning higher we may need to roll our positions out to 2016 but the cost of doing so will be similar (or possibly less) than what we are paying for the 2015 contracts today. So, if the premiums on the 2016 contracts are much higher than double the 2015 premiums we may be spending more than necessary by buying the later expiration contracts. At the beginning of the series it was approximately a difference of 11 months or 23 months duration. Now, the difference is much greater so I will need to add a simple calculation. Determine the amount of premium you would need to pay per month for each contract of different durations. Today, I would divide the January 2015 premiums by ten and the January 2016 premiums by 22. Then compare the two numbers to see which is smaller. I always choose the smaller premium per month unless the difference is within ten percent. That is just my rule and there is nothing magic about the percentage. Again, the detailed explanation is shown in the example below.

The third step is to run a simple calculation in a spreadsheet to determine where we can expect the most potential gain if the stock hits the target price. I have three inputs in this order from the top of the spreadsheet: the option premium for the contract being considered; the strike price for that same option; and the target price on the stock. From these numbers I create a few simple formulas to determine the following: cost per contract (100 x the option premium); the potential future value per contract (strike price - target price x 100); the potential gain per contract (the potential future value - cost per contract); and finally, the potential percentage gain per contract (the potential gain per contract / cost per contract). This provides me with an estimate of the percentage gain I expect if the stock price falls to the target price.

The final step is to determine the number of contracts. I believe that this has been covered extensively in the articles so I will only point out that the cost per contract used in the calculation is derived simply by multiplying the premium price by 100 and that this number is shown below in the example spreadsheets labeled $/Cont. I use a separate spreadsheet for this calculation.

Now we can work through the example on UAL. Our target price was $15 and in the original article on UAL and remember that the premium was $0.44 for a strike price of $20. The difference between the strike price and the target price was $5.00 ($20 - $15) which is more than ten times the premium, so it gives us a starting point. The optimal contract changes over time as the price of the underlying stock moves up or down. Today I would immediately be drawn to the January 2015 put with a strike price of $25 and premium of $0.69 because the premium is obviously less than ten percent of the difference of $10 between the target and strike prices ($25 - $15). This is used as a reference or starting point for steps two and three.

We then look at the premiums for put options on UAL with expiration in January 2016 to compare. Taking up from where we left off on today's example, the put options with a strike price of $25 for the January 2015 contact premium is $0.69 while the January 2016 contract premium is $2.19. We want to convert these premiums for comparison purposes into monthly units. Dividing the 2015 premium by ten months (remaining to expiration) results in $0.069 per month and dividing the 2016 premium by 22 months (remaining to expiration) results in $0.10 per month. The 2016 contract is 31 percent higher per month so I choose the 2015 contract. If the difference were less than ten percent I would choose the longer duration option.

Now, in step three, is where we determine which strike price is best. In my spreadsheets below you will notice that I have constructed it in two mirror pieces so that I can compare one strike against another. All I do is enter the option price, strike price and the target price into the spreadsheet and the rest is calculated by the formulas as described in step three above. You will also notice that I have included the outcomes for prices of the underlying stock in case the market goes down more than I expect to see how much additional return I might expect. I have set the interval here at $1 but I often find it necessary to adjust that lower or higher depending on the target price; above $20 I use a $2 interval; between $12 and $20 I use a $1 interval; and below $12 I generally use an interval of $0.50.

In the first spreadsheet I am comparing the put option contract for January 2015 with strike prices of $25 with the one at $27. The column to look at here is the Exp. % gain on the outer bounds of either side. This tells me what the potential percentage gain would be if the underlying stock were to drop to the target price. You may have guessed here that I like the $25 strike in this example. Since, the results worsen as the strike rises, next I compare the $25 strike contract to the $22 strike contract and find that the $22 strike contract has a much higher potential percentage gain.

Op price

0.69

0.95

Strike

25

27

$/Cont.

69

95

Exp. % gain

Exp. Gain

Future value

Gain per share

Target Price

Target Price

Gain per share

Future Value

Exp. Gain

Exp. % gain

1349%

931

1000

10

15

15

12

1200

1105

1163%

1494%

1031

1100

11

14

14

13

1300

1205

1268%

1639%

1131

1200

12

13

13

14

1400

1305

1374%

1784%

1231

1300

13

12

12

15

1500

1405

1479%

1929%

1331

1400

14

11

11

16

1600

1505

1584%

2074%

1431

1500

15

10

10

17

1700

1605

1689%

As I continue my comparisons I find that the $20 strike has a slightly better initial outcome than the $22 strike contract. However, when the expected gains are similar at the target price I prefer to choose the higher strike. I do this because if gives us more room for error in case the underlying stock does not fall as much as expected. You can call that whatever you want, but for me it increases my chances of being right and that is what I want.

Op price

0.29

0.41

Strike

20

22

$/Cont.

29

41

Exp. % gain

Exp. Gain

Future value

Gain per share

Target Price

Target Price

Gain per share

Future Value

Exp. Gain

Exp. % gain

1624%

471

500

5

15

15

7

700

659

1607%

1969%

571

600

6

14

14

8

800

759

1851%

2314%

671

700

7

13

13

9

900

859

2095%

2659%

771

800

8

12

12

10

1000

959

2339%

3003%

871

900

9

11

11

11

1100

1059

2583%

3348%

971

1000

10

10

10

12

1200

1159

2827%

One last thing about the example: just because the expected percentage gain is higher is not the only reason to select a particular contract strike price. I need to be comfortable with the target price and so do you. If there is even a slight doubt in my mind as to whether we will achieve the target price I will either adjust my target price (usually) or I will just move up to a higher strike where I feel more comfortable. In the case of UAL I am comfortable with the target, but if you are not as comfortable as I am, then you should consider either the $25 strike or the $27 strike. Either will still provide good protection. You will pay a little more but I find that comfort with my decisions (I call it conviction) is always worth a little more.

Finally, I want to also provide two more bits of information that you may find useful. The first is a link to a tool that I use to estimate the volatility of options at IVolatility Options Calculator. Getting a sense of the volatility of an options contract is important because the higher volatility contracts generally provide better returns faster (common sense). Try plugging in a few for the contracts we are watching and then try a similar contract for a large blue chip stock like Microsoft or Procter and Gamble. You will see the difference. The other thing I want you to consider is that when you are adding positions over time as I do, be flexible and consider buying a few contracts each time if you have a large portfolio. Also, consider buying contracts with different strikes moving higher as the premiums fall over time. I expect to own contracts for the same company's stock with two or more different strike prices, usually moving to higher strikes as I make new purchases. I do not do this with all of the candidates, but you will see if you do the calculations that there are often several strikes available that can produce the gains (and thus the hedge coverage) that we seek. And then sometimes there is only one strike that works.

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 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.

Source: Protecting Your Equity Portfolio For Less - Part XIII