By Mark Bern, CPA CFA
Let me start by saying two things:
- I am primarily a buy-and-hold, long-term investor who just wants to hold onto most of my hard-earned gains while not giving up the income that has built up over the years.
- I also want to keep as much of my portfolio working for me as possible, so I do not want to spend a lot on a hedging strategy.
I need to point out that this article and the remaining articles in the series are rewritten from a series that I began under the pen name of "K202." That series is titled "Protecting Your Equity Portfolio For Less." The strategy is the same and I will be using the same companies, but I will attempt to illustrate my points a little more concisely. The reason for republishing this series is to begin writing under my own name, rather than anonymously, and to have this series included in the premium program at Seeking Alpha, making them exclusive to this site. The reasons for publishing anonymously that existed previously no longer exist.
My writing is focused on the conservative, buy-and-hold type investor. Some may disagree with my approach being labeled conservative, but I believe that the longer you read my articles, the more you will understand my aversion to risk and the role that my strategies play in reducing my overall portfolio risk.
This article is not meant to predict a market crash. Market corrections and crashes happen over the course of an investing lifetime. Such events are "risk" to the investor who panics and sells after stocks have fallen significantly in value; but to the buy-and-hold investor, such events are "volatility," and represent buying opportunities. The current bull market, by historical standards, is now longer in duration than all but three bull markets since the Great Depression (see this article from Forbes for a great chart) out of a total of 15. I try not to time the market per se, but when we get this deep into a bull market, I find it to be prudent to consider protecting what we have accumulated. Better opportunities to add to our positions will present themselves. I prefer to not risk suffering a huge setback and the need to climb back out of another hole like those formed in 2002 and 2009.
As a buy-and-hold investor, I select stocks of companies that can weather the storms better than competitors. I generally only invest in dividend-paying stocks that have a strong record of increasing dividends because, over the long term, a significant portion of the total return on large cap stocks comes from dividends. It can amount to more than 50 percent of the total return over a lifetime of investing, according to this article by Dreyfus.
Thus, I am primarily concerned with two aspects of investing: increasing income and preventing the loss of capital. That is why I try to be selective. One bankruptcy can wipe out a significant piece of your hard-earned returns. Avoiding losses keeps the portfolio growing and compounding at a much better clip in the long run.
Used for speculation, options are a very high-risk form of gambling. But, used correctly, options can either add income to a portfolio or provide protection against downside portfolio risk. In this article, I will introduce a strategy to hedge you equity portfolio for less than three percent per year against significant losses.
I dislike those inevitable bear markets (or crashes) that happen when we least expect. While a true buy-and-hold investor holds their respective stocks during a crash, it can still be painful, nonetheless. It often takes a year or more to regain the lost ground given up during the sell-off. It can also be expensive to hedge using most hedging methods. That is why I have developed a method far less expensive to employ, with the potential to pay for itself even when the market does not crash.
Let me now explain why holding a diversified basket of put options for stocks of companies that we may otherwise never buy can provide more downside protection for less cost than trying to use options for the companies that we own. Think about this for a moment: we try to buy and hold the best companies available that traditionally go down less, on average, than the overall market, pay a constantly rising stream of dividends, have sustainable advantages, and boast great balance sheets; why would we want to bet against ourselves? I propose that we buy puts on companies that have the opposite traits: companies for which the respective stocks get hammered in every downturn, which pay a dividend that often gets cut during recessions, have excessive debt loads, and generally experience volatile revenue trends during recessions.
These companies' stocks are more likely to drop much more than our portfolio in any significant downturn, allowing us to buy out-of-the money put options for much less, while achieving similar levels of downside protection. It is important to understand that I do not recommend that an investor try to protect a diversified portfolio by selling put options on a single stock. I will provide an overview of candidates in each article in this series, and it is my intent to build a basket of put options from a diversified group of stocks that should, in aggregate, fall much faster and much further than a portfolio of well-selected, quality stocks. It is not necessary to match sector-by-sector what we own. The point is to make sure to hold several put option positions from a diversified group of stocks representing a relatively broad swath of the economy. It is always possible to have a miss or two, but on the whole, we will achieve our objective.
On the other side of the coin, some of these companies may not require a major crash to take their respective stock prices down significantly. As I mentioned earlier, if one or two of these stocks takes a good tumble, the entire cost of our put insurance could be paid from those gains, even if the broad market does not suffer a major decline.
I am writing about this strategy now, instead of waiting for the top I expect to materialize, in order to keep the cost low. None of us knows with certainty what will happen next. The market continues rising nearly uninterrupted since the beginning of 2013, with the exception of a small correction of less than six percent from recent record highs earlier in 2014 (based on S&P 500 Index). I am hoping that more people are now thinking about the risk that is inherent in equity investing. The premiums we pay while equities are still moving up are smaller than when the market turns south.
I don't advise investors to initiate their entire protection position all at once. There are always rallies to take advantage of along the way and, assuming that we still have higher highs coming in the future, it would be more prudent to take only a portion of the position today and wait for a better opportunity to buy contracts at lower prices in the future. I have already purchased about two-thirds of my position, but I believe that there is still plenty of time to get hedged.
With the tapering of QE by the Fed, it seems to me that investors are becoming more selective. It also means that fundamentals are beginning to matter again, and that is a good thing for those of us who actually do our homework.
Over the coming week or two, I will provide at least sixteen candidate stocks and selected respective stock options (one or two per article) for companies poorly-positioned to weather a bout of economic weakness. In order to create a hedge, each investor should select at least eight positions to form a diversified basket, either from the sixteen to be provided or similar companies. I will suggest an option contract for each, with a buy up to price for each that should provide a balance between potential return and initial cost.
I will discuss the cost and benefits of this strategy more fully in the next article. The last item I want to discuss in this article before I present the first candidate is how to determine how many contracts to purchase for each position.
The first thing each investor needs to decide is whether s/he wants to be fully hedged or only partially hedged. Either is fine. The less hedged you are, the more downside risk you are exposed to in a major crash. On the other hand, the more hedged you decide to be, the higher the cost. This strategy will reduce your potential returns if no crash occurs during the holding period. I fully expect a significant downward plunge in stocks sometime during the next 18 months. My expectation is for a drop in the S&P 500 Index and DJIA Index of at least 30 percent during this time frame. It may be less or more, but that is the basis for the coverage I recommend. If it is worse, applying this strategy will continue to provide protection. If it is less, this strategy may only provide partial protection. But something is better than nothing in the wake of a 25 percent market decline. By the end of two weeks, you will be able to make adjustments to my suggestions in order to align with your own expectations. I will explain in greater detail how to do that in the next article.
I will be recommending contracts with January 2015 expirations. If there has been no downturn by that time, it may be necessary to roll over our positions into January 2016 contracts later in 2014 or early in January 2015. For each contract on each company's stock I will provide an expected return on the option in the event we experience a major crash. Thus, if you decide to choose eight stocks and want to be 100 percent hedged; you would assign a value of 12.5 percent to each position. Then you take the total value of your portfolio multiplied by .125 (12.5%) to determine the portion of your portfolio you want to protect with each of the eight selected option contract positions. Next, you multiply that amount by .3 (30%) to determine the dollar amount of loss you want to protect against. Using this dollar value, you divide by the expected gain per contract to determine the number of contracts you will need to purchase in total. Remember, I am suggesting entering these positions a few at a time, because I believe we will eventually get at least one more good rally before we find the long-term top for this bull market. I will provide examples of this calculation based upon a $100,000 portfolio to keep it simple for adjustments to the numbers to reflect the actual size of your portfolio. If your portfolio is closer to $500,000, for example, it will simply require you to multiply each position I suggest in the examples by five.
Now if you only want to hedge a portion of your portfolio, say 50 percent, the adjustment will be to multiply the contracts you calculate for 100 percent coverage by .5 (50%), or by whatever percentage of your portfolio you want to protect. Again, some protection is better than nothing.
I want to now reveal my first option protection candidate. In every recession, the major airlines end up losing money. In the last recession, even the smaller (but still growing) Southwest Airlines (NYSE:LUV) saw EPS fall nearly 70 percent. United Continental (NYSE:UAL) is nearly double the size of LUV and, even after going through bankruptcy and restructuring, does not exhibit the strong margins of LUV necessary to get through a recession without posting heavy losses. UAL earned $571 million in 2013 on revenue of $38.3 billion. That yields a net profit margin of 1.49 percent. LUV had a net margin of 4.26 percent in 2013.
The airlines suffer significant losses during recessions, because the industry requires large capital costs that cannot be pared during periods of slack demand. When a recession hits, people fly less and drive more, taking vacations closer to home. Businesses cut travel and do more meetings using vastly improved technology during economic downturns. Airlines cannot reduce costs fast enough to match reductions in customer demand. Layoffs can actually add costs in the first year. Idling planes that are leased or owned does not reduce fixed costs. Until UAL can more than double its net margin, the company is very likely to post losses in future recessions, and the stock will take the inevitable hit.
Now, I want to look at some of the criteria I use to identify candidates: total debt equals 83 percent of UAL capital as of September 2013. Standard and Poor's rating on UAL debt is B (below investment-grade). Revenues dropped significantly in each recession. The company does not pay a dividend. Both operating and net profit margins have fallen since 2011 and, of course, when there is no profit (as in 2008 and 2009), the profit margin turns negative. Additionally, the trailing P/E is nearly 26. That is high for this company at this stage of the economic recovery. Overall, I think UAL is an exceptional candidate for the protection strategy.
Let us look at the available put options. I realize that there are January 2016 options available (which could extend the protection over a longer period), but the prices in the range I want to buy cost more in premiums per month than what we need to pay for the same strike price for January 2015 contracts. If the economy keeps chugging along and the UAL stock price ends up higher that it is today, we should be able to purchase another set of contracts for January 2016 expiration for a price/month similar to what we would pay today for 2015 contracts. This makes it cheaper to buy the 2015 options and roll into the 2016 options, if necessary. Why tie up more money unnecessarily? Looking at it another way; if the market falls significantly in 2014, we would make more from the 2015 expiration puts than 2016 expiration, and do so for a lower cost.
My expectation is that UAL stock will once again fall below $15 if the U.S. economy dips back into recession, even though the stock dropped much further in the last recession from an even higher level. Based upon the assumption of a $15 price target, my favorite strike prices for January 2015 put option contracts, as of the market close on April 29, 2014, on UAL is $20, with a premium of $0.24 per share ($22 per contract of 100 shares plus commissions). If the price falls to $15 on a put option with a $20 strike price, our contracts would be $5 in the money. Depending upon how long the contract has before expiration, we may end up with all of the $5 or slightly less. Collecting $5 per contract gives us a profit of $476 per contract (minus commissions). To protect 1/8th of a $100,000 portfolio against a 30 percent loss, we need eight contracts. The cost would be $192 (plus commissions).
Assuming a $100,000 equity portfolio, to protect against a market loss of 30 percent (or $30,000), using eight distinct positions (contracts in eight different companies) each position would need to provide us with $3,750 in protection. The UAL position described is designed to protect 1/8th of a $100,000 for about $192, or 0.19 of one percent of the total portfolio, and should protect against approximately $3,800 of portfolio loss.
In the next article of this series, I will explain how this strategy can benefit long-term investors in greater detail. The third article of this series will include a basic tutorial about options used in this manner. The fourth article of the series will provide an explanation of how I select the option contract to be used for each company. The fifth article will include an explanation of why I do not use Index ETFs, especially the leveraged ones, for this strategy. Each of the remaining articles will focus on multiple candidates to be considered for the strategy. Once I have introduced all candidates, I will provide an article explaining my exit strategies. I will continue to add future articles to the series, as market conditions warrant.
Finally, I need to point out that if the market does not fall significantly before these options contracts expire, we will lose 100 percent of the cost of employing this strategy. That is the way most hedges work. Insurance is never free! That is also why I like to keep the cost as low as possible.
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 do own the puts on UAL described in this article.