By Mark Bern, CPA CFA
In the first article of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. In Part III, I provided a basic tutorial on options.
In this article, I will provide an explanation of how I choose the options contracts. I will also provide two more candidate stocks to consider for use in this strategy.
I want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets.
What could cause the next recession? According to an investor survey from Blackrock, investors are still nervous and holding onto cash. But according an analysis by Young Research of the latest data on household financial assets from the FED, "The percentage of investors' financial assets in such riskier investments is now 34.9%, just shy of the highest exposure to risky assets since the 1950s - 38.4% in the first quarter of 2000." If investors are already near the maximum allocation to risky assets, where does the additional support of the bull come from? That is not to say that we have peaked. Who knows how much investors will actually invest? History may or may not be meaningful.
We are already past the average duration of all bull markets since 1929. The current bull market has now surpassed in length all but three bull markets during that time period (out of a total of 15). So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, but experience tells me that we are probably within 18 months of when we will need to be protected. I do not enjoy writing about down markets, but the fact is: they happen. I don't mind being down by as much as 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 and second articles of this series. Without that foundation, the rest of the articles in this series may not make sense and could sound more like speculating with options.
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 those provided in 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, 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. I compare the cost per month of similar contracts with different expirations. 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 continues 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. Determine the average cost of a premium per month for each contract of different durations. Today, I would divide the January 2015 premiums by eight and the January 2016 premiums by 20. 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.
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. If the percentages are close from one strike to the next, I will choose the one with the higher strike. That allows the potential gains to accumulate earlier as the stock price tumbles.
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 is $15 and the premium is $0.24 (from the first article) 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 there are several strikes that could work, from $18 to $25. 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. In the example, the put options with a strike price of $25 for the January 2015 contact premium is $0.65, while the January 2016 contract premium is $2.12. We want to convert these premiums for comparison purposes into monthly units. Dividing the 2015 premium by eight months (remaining to expiration) results in $0.081 per month, and dividing the 2016 premium by 20 months results in $0.106 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.
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.
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 $27 strike contract and find that the $25 strike contract has a much higher potential percentage gain.
As I continue my comparisons I find that the $20 strike has a better initial outcome than the $22 strike contract.
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 a doubt in my mind 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 comfortable, then you should consider going as high as the $25 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).
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 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.
I will now present the next two candidates. Both are within the services sector but neither is in the same industry, so using them both is fine if you like these best out of the group. The first candidate is Sotheby's (NYSE:BID), which is currently trading at $43.27 (nearly 20% below the 52-week high of $54). Again, the shorter simple moving averages [SMA] have moved below the 200-day SMA as has the price, exhibiting weakness. If you look at the long-term chart for BID, you will see that the stock price has peaked before each of the last recessions. Bubbles create new wealth and people with new wealth tend to like to show off how rich they are. Today the newly rich in China are bidding up art, jewelry and collectibles to record levels. A little weakness is beginning to show up, and thus the price of BID has already begun to fall.
During the last two recessions, BID's stock price tumbled 86 percent from $46.59 in 1999 to $6.42 in 2003 and 90 percent from $61.40 in 2007 to $6.05 in 2009. When fear enters the marketplace, no matter from what corner, BID revenues and profits fall because the rich are not willing to place record bids. The smart buyers swoop in to buy what "must" be sold when economies lose steam and income producing assets must be protected at the cost of selling collectibles (which pay no interest or dividends).
The current beta for BID is 2.38, according to Yahoo Finance. Revenue fell 31 percent from 1999 levels and EPS went from $0.56 per share in 1999 (already down from $0.96 in 1998) to a loss of $0.37 per share in 2000. Annual losses continued until 2004. During the Great Recession, revenues fell 48 percent from 2007 to 2009 and EPS dropped from $3.12 to a loss of $0.12. Common shares outstanding have risen slightly and debt is very nearly unchanged since 2009. One thing that sticks out for me is that BID suspended its $0.10 per quarter dividend in 2000, then reinstated a dividend in 2006, raising it to $0.15 per quarter by 2008 and then cut the dividend in 2009 to $0.05 per quarter. Since then, BID raised the dividend to $0.08 per quarter in 2012, paying out $0.28 in the fourth quarter and then not paying any dividend in the first two quarters of 2013. It has since paid quarterly dividends again at $0.10 as of quarter three of 2013. This tells me that BID management views the dividend as something like a go-to cash management tool. That does not set well with investors. Another recession is likely to cause BID to suspend the dividend again and, combined with the inevitable drop in both the top and bottom line, will cause BID shares to fall quickly. I expect that during the next economic downturn, BID shares could easily drop below $16.
My choice of options for BID is the January 2015 contract with a strike of $28 and a premium of $0.69 (however, the ask price is $0.55). At $0.69 the potential gain, if the price falls to $16, will be about 1,639 percent ($28 - $16 = $12; $1 x 100 shares = $1,200; $1,200 - $69 cost = $1,131; $1,131 / $69 = 1,639%). We need three contracts to protect approximately $3,393 of a $100,000 portfolio. Remember, we are trying to protect against a 30 percent general drop in stocks and want a total of $30,000 in gains to offset potential losses should we experience another recession.
The other candidate for today is L Brands (NYSE:LB) from the retail sector, and specifically from the soft goods (apparel and accessories) retail industry. LB is one of the largest retailers of apparel, lingerie and personal care products with approximately 3,000 outlets. When the economy hits a rough patch, many consumers tend to spend less on discretionary items and this company is brimming with products that fall directly into that category. From 2000 to 2002, sales fell from $23.63 per share to $16.15, and the share price fell 83 percent from $51.69 to $9.00. The drop in revenue was less severe during the Great Recession, but EPS dropped by 66 percent and the share price fell 79 percent as a result, from $29.05 to $2.41. The debt-to-capital ratio for LB was 121 percent as of November 2013, with total debt growing from $2.7 billion in 2009 to nearly $5 billion. Three uses that management has had for the cash from the added debt: buying back shares, raising the regular dividend and paying large special dividends. Investors love to receive the dividends, but will likely leave the stock when margins and profits begin to fall again. The company's balance sheet is in far worse shape than it was in either of the prior economic downturns, weakening the company's ability to withstand the next one. The return of all that money to shareholders has turned shareholders' equity and book value negative. I expect that the stock price could drop to $16 or less during the next recession. The current price (as of the close on Friday, May 2, 2014) is $54.51, giving us a lot of potential downside.
I like the January 2015 put option with a strike of $34 and selling for a premium of $0.30 per share. The cost per contract is $30 (plus commissions), yielding a potential gain of 5,900 percent ($34 - $16 = $18; $18 x 100 = $1,800; $1,800 - $30 = $1,770; $1,770 / $30 cost = 5,900%). We only need two contracts for a total cost of $60 (plus commissions) to provide $3,540 of loss protection for each $100,000 of equity value in my portfolio. That cost equals 0.06 of one percent of the portfolio to protect 12.5 percent of the portfolio against a 30 percent loss. Because of the potential return, you may be tempted to buy more than the two contracts needed. Do not get too greedy. This is only a hedge. An alternative is to buy one $34 strike contract and another with a strike as high as $49. The $49 strike sells for a premium of $2.50 and yield a potential gain of 1,220 percent. Actually, there are several strikes that work for LB between $31 and $49. You should find the one or two that combine to make you comfortable. Make sure to stay away from contracts with little or no open interest or volume. I like to have open interest of over 100 contracts and at least some volume on most days.
I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2015, all of our option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes, and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration in January 2016, using from three to five percent of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible.
Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as three percent) to insure against losing a much larger portion of my capital (30 percent). 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 may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins in 2014; but if the bull can sustain itself well into 2015, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues.
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 put options on LB as described in the article.