The article introduction contains a brief overview of the series, links to more detailed explanations and why I think 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 second batch of options purchased is listed here including the strike prices, premiums and a brief discussion of why I chose these candidates.
The article concludes with a discussion of the risks of employing this strategy versus not being hedged.
By Mark Bern, CPA CFA
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 provide a list of the second batch of options I am purchasing and a brief explanation of why I chose these candidates at this time. 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 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. 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 we will take a look at my second round of put options that I am buying and a brief explanation of why I chose these candidates.
I am adding full positions of each of the six new candidates I will list in this article and completing the two half positions I started in the first round. 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 want to stress that readers who decide to employ this strategy should choose eight candidates total from all of those I have listed in this series. Choosing two or more from each of the lists that I present in my four rounds of purchases is fine.
The companies that I want to buy put options on in this second round are chosen for multiple reasons: the stock may have fallen faster than the average of the group during the previous recessions; the stock has exhibited weakness relative to the broader market even as the S&P 500 was hitting new highs; or the stock appears to be significantly over valued in my opinion. As I have stated previously I believe that the market may still head even higher in the short term (I may become less confidence if the market continues to weaken further), 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. I had thought that the S&P 500 index would get closer to 1900 before showing signs of weakness. It did so last week on Friday and then retreated after reaching 1897.28 and then closing at 1865.09. Today, the market fell further with the S&P 500 closing down another 20.05 points to 1845.04.
Here is a link to a short video from CNBC featuring Dennis Gartman, fund manager and editor of the Gartman Letter, telling investors to get out of stocks. His reasoning is based upon something unusual that happened on Friday. Early in the day he was 100 percent long and the between 11 a.m. and 11:15 a.m. something happened that he had not experienced in his four decades of investing. I also noticed this article from Reuters about an EU investigation into thirteen global investment banks (Citibank, Goldman Sachs, Bank of America, Deutsche Bank, Barclays, Bear Stearns, BNP Paribas, Credit Suisse, HSBC, JPMorgan Chase, Morgan Stanley, RBS, and UB) claiming the banks had blocked exchanges from entering the lucrative credit default swaps (CDS) business between 2006 and 2009. This is not a new action, but it appears that the EU intends to extract significant penalties, in my opinion, and do so in a very public manner to look tough. The anticipated fine is rumored to be as much as ten percent of global turnover by the defendants. That could be a huge number and also could create concern regarding the stability of the financial system again. I find this to be very ironic; bail outs lead to profitability which leads to huge fines leading to financial instability requiring more bailouts? I just do not think we can make this stuff up! Both of the links are relatively obscure and neither is likely to actually impact the market. But one never knows for sure and, other than the imaginary resistance of 1900 on the S&P 500, I see no real reason for the market correction to begin yet. I have been wrong before on timing issues and will be again. If I were really good at timing I would have written this article on last Thursday.
I will list the ask price as of the close of the market on Monday, April 7, 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 we place orders within 24 hours. If the selected stocks fall further on Tuesday 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, the strike price and the premium for each option, as well as the number of contracts I am buying for each $100,000 of my portfolio that I am protecting 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 I 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 a minimum of 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 Morgan Stanley (NYSE: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 $60 (plus commissions) to protect slightly more than the required $1,875 for a half position. That amounts to only 0.06 of one percent of the portfolio for this one half position.
The total cost of all six positions listed in the table above is $1,272 (plus commissions) to hedge against a loss of approximately $26,250 of a $100,000 portfolio, or almost 88 percent of a 30 percent drop in portfolio value. In case the percentages and coverage is confusing, I want to point out that I am buying all 17 positions and am listing everything that I am buying. You should be picking out at least two positions from each of the four lists that I will include in the four articles in this series during which I am detailing my purchases. Or you can purchase more than two while only buying partial positions.
Using the average cost of all positions purchased in this and Part XI, our total hedge would require approximately 1.35 percent of the portfolio. If the bull market continues we should 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. I hope you agree.
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 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 completing the rest of the two partial positions in Jabil Circuits (NYSE:JBL) and MS that I started in the last article. I elected to switch to the $10 strike price on the JBL contract because the return potential relative to the cost was so much greater. The one-year chart of JBL looks very weak to me as the trend appears to continue in a downward slope. Looking at the one-year chart for MS, the 50-day simple moving average [SMA] just crossed below the 100-day SMA and the trailing price/earnings [P/E] ratio is 21.7. My long-term expected P/E for MS is about 12. Also, there are several legal battles for numerous grievances against MS and other large banks such as the one above and this one which could weigh on financials.
Likewise, E-Trade Financial (NASDAQ:ETFC) is trading at an unsustainable P/E of 68.8 while core revenues appear to be falling. This falls into the overvalued group as do Tempur Sealy (NYSE:TPX) sporting a P/E of 36.6 and Terex (NYSE:TEX) at 21.2. My expected, long-term P/E for these two is 15 and 13, respectively. Marriott (NASDAQ:MAR) also remains pricey in my book and the 50-day SMA is heading decidedly lower toward the 100-day SMA again. When a recession starts MAR is usually one of the first stocks to fall. Micron Technology (NASDAQ:MU) share price has fallen below both the 50-day and 100-day SMA and has also broken below strong support levels. Goodyear Tire (NASDAQ:GT) tends to bottom early in recessions and, even though projected car sales are expected to be at record levels in 2014, new car inventory has ballooned. But GT derives about 70 percent of its revenues from the replacement sector so that should not be a big issue. However, tire durability has improved which leads to less frequent replacements I expect GT revenues to be flat in 2014 compared to 2013. That could make the company more susceptible if a recession starts.
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.
Additional disclosure: I am in the process of purchasing the options listed in this article with the intent to complete those purchases within the next 72 hours.