In the Part I 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 why I do not use ETFs or the respective put options. 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.
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.
Once again, instead of answering the question what could cause the next recession, I will do my best to explain my exit strategy for the options positions covered in this series. First it depends upon the economy and how the stocks are being affected. It also depends upon what each individual investor wants to achieve from the hedge. Please consider three concerns I have: first, readers will be able to imagine an unlimited number of possible scenarios; second, each investor has his/her own goals and expectations; and third, how and when the next downturn unfolds is impossible to predict. Thus, it is virtually impossible to list all possible outcomes and construct the ideal set of rules to optimize results for all of them. If readers have suggestions that will add to or improve what I provide here, please share those thoughts in the comment section where we can all benefit from the discussion
If the market does not turn bearish by the January expiration or if it has turned bearish but has only just begun to fall by that time, we will need to roll the positions over into option contracts with expirations further out. How far out we go will depend upon the condition of the market and the economy at the time. It is entirely possible that I will begin to roll my positions as early as November 2014 if the market appears to still be in recovery mode.
I realize that there are some readers who are concerned that we will not be able to get the bargains at that time that we are getting now and that the cost to maintain the hedge will increase. Remember, though, that the extrinsic portion of the option value is related to time to expiration and that if the price of the underlying stock is higher or near the same level as today, that portion of the premium will decay (be reduced) over time. If stocks go up higher we may be able to find options at very reasonable prices later in the year, even as we move the strike prices higher to accommodate the price rise. That means that there should be larger profit potential per contract so we will need fewer contracts to offset some of the higher cost.
If the market begins to fall before expiration but has not yet fallen far enough to provide the protection we desire we will still need to roll our positions. This is the most difficult scenario to judge. Our options should have some profits in them that we can take to help offset the additional cost of new positions further out.
Now I would like to explain what circumstances will motivate me to remove my hedge. It is tricky and close to impossible to know with certainty when the market or an individual stock has hit bottom. But, we can get close by following some rules.
Rule Number 1
If the market falls faster and further than I expect the underlying stocks represented by our options may go down to lower than my targets. If any of the stocks get near their respective lows during the Great Recession I will sell my puts for those stocks because there will just not be enough left to justify holding the positions any longer.
Rule Number 2
If the market exhibits a day of capitulation with a relatively strong reversal at the close, it is often a good sign of a significant bottom. This is really hard to pick correctly because emotions are running wild and there is a fear that things could get even worse. March 6, 2009 was more obvious in retrospect. The S&P 500 index opened at 684, then fell to 667 and closed at 683. The DJIA Index opened on the same day at 6595, then fell to 6470 before closing at 6627. If (and this is a big "if") I identify this type of price action on an individual stock or the major indexes, I will try to sell to close my hedge positions as soon as possible. I may keep some (less than half) open just in case I am wrong, in which case I will use rule number three to determine when I close the remaining positions.
There have been some false positives as in 2001 just after September 11th. I took most of my positions off early then, but the market went down further in 2002. Admittedly, I got out over 180 points above the eventual bottom. In 2009, I got out of half of my positions in March but held onto the rest until late June because I was still nervous. I saw the capitulation and sold half but I waited until I was sure the bottom was in before selling the rest. That brings me to…
Rule Number 3
This one is straight forward. I will be watching both the major indexes and each stock I own put options on and the sell to close is automatic when the following happens. The price of the underlying stock must rise above the 200-day simple moving average [SMA] and the 50-day SMA must rise above the 200-day SMA. I have found that when that occurs, the bottom for the index and/or stock has usually been made. By employing this rule we will miss some of the potential profit/coverage of the hedge. But, at the same time, our portfolio (being full of high quality stocks) should rise faster off the bottom so that our hedge will still be working until we close the positions. I do not hold any put option positions once major market indexes have formed this pattern.
Those are the rules that I use. If anyone reading this article can add to them in a constructive manner, please do so in the comments.
The semiconductor industry is one of the more volatile investment areas. Several of the companies in this industry have not yet recovered from the Great Recession, while others that have more cutting-edge technology have shot to new highs. Micron Technology (NASDAQ:MU) shares have been boosted by a leak about a major investor taking a large position some weeks ago. That will probably end up in court. For us, it may provide an opportunity as the share price continues to hold onto most of the gains. MU recently made two acquisitions, which should bolster future revenue and profit prospects. On the other hand, pricing pressure in the NAND sector has depressed pricing and margins, and it looks likely that this trend will continue over much of 2014. MU's business is very cyclical and, while the company does extremely well at times, it also does very poorly in downturns. The company has posted a profit in only eight of the last 17 years; nine years resulted in losses. EPS fell from $0.25 in 2006 to a loss of $2.29 per share in 2009. In 2012, MU lost $1.04 per share. In 2013, the company recorded a profit of $1.13 per share. The debt-to-capital ratio seems reasonable at 33 percent, but long-term debt has climbed from $1.6 billion in 2010 to nearly $4.5 billion in 2013. However, the cash position is strong, so MU will likely weather the next recession. The share price hit $91.00 in 2000, but dropped to $6.60 per share in 2003 for a 93 percent decline. In 2007, the stock hit $14.20, but fell 89 percent by 2008 to only $1.59. Orders slow considerably for MU in a recession, and even with the new acquisitions I expect little change in the next economic downturn. My price target for MU in the next recession is $5.00. The current price is $26.86 (all quotes are as of the market close on Wednesday, May 14, 2014).
There are several January 2015 put option contracts that could work well. My choice at this time is to buy the strike of $12 with a premium of $0.10 (ask) for a potential gain of $690 per contract (before commissions). When I write the summary article I will list all the option contract strikes that would work for each candidate.
With the cost per contract of $10 (plus commissions), if MU stock falls to the target price of $5, it has the potential of producing a gain of 6,900 percent ($12 - $5 = $7; $7 x 100 shares = $700; $700 - $10 cost = $690; $690 / $10 = 6,900%). Buying six contracts will provide protection for $4,190 of our portfolio.
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 18) 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 six contracts. The cost is $60 (plus commissions) to protect slightly more than the required $3,750. That amounts to only 0.06 of one percent of the portfolio.
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 will need 24 contracts (400,000 / 100,000 = 4; 4 x 6 = 24). 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 24 contracts calculated above by .5 and you find that you need to buy 12 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.
The next candidate is a company that was a high flyer during the dot com boom days. Level 3 Communications (NASDAQ:LVLT) soared all the way up to $132.26 by March of 2000. The stock then dropped to $1.89 by October of 2001; a 99 percent descent. Then in July of 2007 the stock was at $6.42 per share only to fall once again to $0.60 by March of 2009, a 91 percent drop. The company did 15-for-1 reverse split in 2011 to remain listed. The debt-to-capital ratio is 88 percent and the company has lost money every year since 1998 (excluding non-recurring items and discontinued operations). Debt has increased by nearly $3 billion since 2009. The beta is 1.9 according to Yahoo Finance. While the company expects to turn a profit in 2014, another recession could derail those dreams and send investors packing again. The shares now stand at $43.34. I expect that in the next recession these shares could easily fall to $12 per share. Take a look at the January 2015 put option with a strike of $20; I think we can pick this one up at $0.15 per share since that is the current asking price (the price at which a seller is offering to sell). If the stock falls to $12 or below by January 2015 we stand to collect a gain of $785 per contract on an initial investment of $15 per contract (plus commissions). For each $100,000 in value of a portfolio, assuming the need to protect against a 30 percent drop, we will need five contracts for a total cost of $75 (.075 of one percent of your portfolio). Adjust accordingly to fit your needs.
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 own put options on both companies as described in the article.