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Summary

  • The article introduction contains a brief overview of the series, links to more detailed explanations and some reasons why I think it is the time hedge against the next bear.
  • A brief discussion of where I believe weaknesses still remain in the US economy.
  • A summary is included listing all the candidate companies that have been provided in the series along with selected options data for each.
  • The article concludes with a discussion of the risks of employing this strategy versus not being hedged.

Back to the May Candidate Summary

If you are new to this series you will likely find it useful to refer back to the original articles, all of which listed with links in this Instablog. 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. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplate regarding possible triggers that could lead to another sizeable market correction.

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 1920. 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 15 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 rather than an inexpensive way to protect your portfolio against catastrophic loss.

I would like to add one last thing about why I am hedging now before I move to my review of the candidates. The stock market has experienced a significant correction in every mid-term election year since 1962. The average drop has been 19 percent. This has been the weakest recovery in terms of GDP growth and jobs creation since WWII. Much of the growth in corporate EPS in recent years has come from cost cutting and stock buy backs. The cost cutting has nearly run its course this time around. The global economy is still growing, but the rate of growth has slowed and much of the developed world is mired in sluggish, slow growth and unable to break out. Put it all together and the second half of this year could see stocks pull back more than the average for mid-term election years. Just something else to think about.

In this article I will provide a table include each candidate company with my favorite contracts to use today including the fields: current price, target price, strike price, bid premium, ask premium, possible gain (if target is reached), number of contracts needed to hedge 1/8 of a $100,000 portfolio against a 30 percent market plunge, the total estimated dollar amount of hedge protection, percentage cost of the portfolio for each position. I have not included all put option contract strike prices that I would consider for the strategy for each candidate; only my favorites at this point in time. The target price for each candidate remains the same as outlined in the original articles regardless of the current stock price or option strike price.

All option contracts listed in the tables expire in January 2015. I have based all calculations upon the ask premium for each contract to keep things conservative. If you are able (which should be the case in many instances) to get a price below the ask price all the calculated numbers will improve. Use common sense when entering a limit order by offering to buy at something above the current bid but below the ask premium. I usually try to split the difference and get most orders filled. The market have moved higher setting new records just as I had previously predicted. I could have waited but I cannot predict with certainty what the market will do with so much stimulus and artificially low interest rates, thus I feel better with a hedged position going into what could be a critical period for stocks. I have not completed my hedge position to protect my full portfolio as yet but plan to do so by the end of this week with major US indexes remaining near record levels. For a more detailed discussion of the economy please refer to this article.

I would also like to explain what I do not include and why. I do not include contract strikes with fewer than 70 contract of open interest; in most cases the cut off is 100. I do not include contract strikes where the last price is far above the currently listed ask premium when there is also current volume listed. It is not clear what the price needs to be to get filled on those contracts. I do not include strikes that do not provide a possible gain in excess of 1000 percent (unless I believe it possible to get a fill below the ask price that will meet that expectation). The cost is just too high to fit within this strategy. Finally, regardless of the open interest, I do not include strikes that have no bid or ask premiums listed.

If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit less than two percent of my portfolio value to this hedge. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work.

The first stock, Sothbey's (NYSE:BID) has already entered a down trend and I expect that trend to continue. Shares are trading below the respective 200-day Simple Moving Average.

BID; S&P credit rating is BB.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 39.13

$ 16.00

$ 30.00

$ 0.85

$ 1.00

1300%

3

$ 3,900

0.30%

BID is one of the most expensive candidates to employ but it has a history of falling below that target price once a recession hits after a bubble in art and collectibles bursts, which is what I believe is happening now in China. I really expect that during a recession BID will get closer to $10 a share

CarMax (NYSE:KMX); Moody's rates the securitized debt at Aaa.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 52.45

$ 16.00

$ 30.00

$ 0.510

$ 0.15

9233%

3

$ 4,155

0.05%

$ 35.00

$ 0.20

$ 0.30

6233%

2

$ 3.740

0.06%

$ 40.00

$ 0.45

$ 0.55

4264%

2

$ 4,690

0.11%

$ 45.00

$ 0.95

$ 1.10

2445%

2

$ 5,380

0.22%

KMX is even more of a bargain! I broke character and listed the four contracts that I think offer the best potential. I like the $30 strike contract the best. The $25 strike contract has a better return and cost profile, but I like to be a little more conservative and have the protection kick in at $35. Needing only 0.06 of one percent is still very cost effective. But here, as in other situations, I will own more than one strike. I already own some at the $25 and $30 strikes and plan to add some of the $35 and $40 strikes this week. Be aware that 2014 is likely to be the peak in the auto sales cycle this time around and that sales could begin to taper off by year end. Thus, this one may be a good one to keep a partial position in until sales begin to fall off or the economy turns a bit more negative. Your choice.

Veco Instruments (NASDAQ:VECO); NR by S&P; Moody's has withdrawn rating.

Current Price

Target Price

Strike Price

Last * Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 34.50

$ 12.00

$ 20.00

$ 0.62

$ 0.80

900%

5

$ 3,700

0.30%

*Using "Last" price paid instead of Bid because there is no current bid. No other contract has enough open interest.

VECO, like BID, is also expensive already. The chart looks terrible. The stock tried to break higher but then fell back into a downtrend. But notice the spread between the last and ask premiums. I suspect we can do much better by placing limit orders either at or close to the low end of the spread. That will make this candidate much more cost effective

Jabil Circuits (NYSE:JBL); debt rated at BBB- by S&P.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 20.68

$ 7.00

$ 15.00

$ 0.15

$ 0.25

3100%

5

$ 3,875

JBL shares have rebounded to give us a better entry point! I will complete my position in JBL this week with the $15 strike contract.

L Brands (NYSE:LB); debt NR by S&P; rated Ba1 by Moody's.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 58.55

$ 16.00

$ 41.00

$ 0.25

$ 0.35

7043%

2

$ 4,930

0.07%

LB is another inexpensive hedge candidate. I own both the $34 and $39 strike contracts, but am considering adding some of the higher strikes as I complete my hedge. Right now my favorite is the $41 strike but I am also considering the $46 and $49 strikes. All of them fit the profile and should work within the strategy.

Seagate Technology (NASDAQ:STX); S&P credit rating of BBB-.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 59.69

$ 20.00

$ 35.00

$ 0.11

$ 0.18

8233%

3

$ 4,446

0.05%

STX shares have climbed since my last review and we continue to have more strikes to choose from at higher levels at great premiums. My favorite is the $35 strike contract but I plan to add some at the $40 strike level as well. The $45 strike contract will also work but the cost is a little high yet for my liking.

Terex Corporation (NYSE:TEX); S&P credit rating of BB.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 39.05

$ 12.00

$ 26.00

$ 0.30

$ 0.40

3400%

3

$ 4,080

0.12%

TEX will fall further if demand for raw materials in China does not improve. China has overbuilt and has stockpiled much of what it will need, so I do not expect an appreciable improvement any time soon. I like both the $26 and $23 strikes best. If one can get the $26 strike contract for a $0.35 premium that would be my choice. I own some of both as well as some at lower strikes, too.

United Continental Holdings (NYSE:UAL); S&P credit rating is B.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 45.22

$ 15.00

$ 25.00

$ 0.31

$ 0.42

2603%

4

$ 3,852

0.15%

UAL has gotten cheaper for us as the stock has rebounded. I like both the $25 and $27 strikes the best. But the $25 strike contract is more cost efficient. Airlines continue to strengthen during the summer vacation season but will, along with recreation and leisure stocks, fall the fastest when the first few major layoffs are announced during the early stages of a recession. These stocks hit bottom even before the recession is reported as official, usually at least seven months after it begins.

Goodyear Tire & Rubber (NASDAQ:GT); S&P credit rating is BB-.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 27.65

$ 8.00

$ 17.00

$ 0.10

$ 0.20

4400%

4

$ 3,520

0.08%

GT offers some good low cost contracts. Why go below the $15 strike contract? The higher strike provides better protection for a reasonable cost. I own both the $15 and the $17 strike contracts.

E-Trade Financial Corporation (NASDAQ:ETFC); NR by S&P; rated B2 by Moody's.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 21.30

$ 7.00

$ 15.00

$ 0.33

$ 0.38

2005%

5

$ 3,810

0.19%

ETFC has already fallen some but has leveled off. But I really think this one will go to the target price in a recession or even a good correction in stocks. I own some of both the $12 and the $15 strike contracts.

Morgan Stanley (NYSE:MS); S&P credit rating is A-.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 32.00

$ 12.00

$ 20.00

$ 0.06

$ 0.09

8789%

5

$ 3,955

0.05%

MS is a mystery in terms of balance sheet transparency. I like any of the contracts with strikes of $17 up to $25. I will probably own more than two different contract strikes within that range before I am finished setting up my hedge. The stock has traded in a range since January. A recession would do considerable damage due to fear related to the last crisis that continues to linger in the minds of investors.

USG Corporation (NYSE:USG); S&P credit rating is B+.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 27.82

$ 12.00

$ 20.00

$ 0.30

$ 0.50

1500%

5

$ 3,750

0.22%

As one reader pointed out, USG shares are being accumulated by Berkshire Hathaway. But after further consideration I have decided to include it as a candidate. The majority of the shares Berkshire has a right to own are through convertible securities with an average price below $21. If Berkshire wants to buy the rest of the outstanding shares at a premium (probably necessary to get board members and shareholders to approve) why would it not wait for an opportunity to get the rest at a price close to the average price it already has? Berkshire has no interest in propping up the share price by paying more than necessary for the remaining shares. Its time horizon is practically forever. So, if the shares fall enough below $21 to make a bid for the rest of the shares at that level look good, I think it will make a move. Until then, it is more likely to bide its time until the value is more evident, in my opinion.

Royal Caribbean Cruises (NYSE:RCL) has leveled off but has not yet established a trend. The best time of the year is just ahead for this company and expectations are high. I suspect that all the good news is already baked into the stock price, so unless there is a positive earnings surprise or reported guidance is adjusted upward I would expect this stock to trend sideways for most of the summer. If the broader market climbs higher, though, RCL could climb with it.

RCL; S&P credit rating is BB.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 54.96

$ 16.00

$ 35.00

$ 0.23

$ 0.30

6233%

2

$ 3,740

0.06%

I recently returned from cruising with my family on an RCL ship (Oasis of the Seas; 220,000 tons) in the Caribbean. I got a really good discount. In a recession, the discounts get even bigger. Mine was over 50 percent and I did not book at the last minute. Margins will crumble if the economy contracts and so will the price. This one is still cheap. I own some at $30 and $35 and am considering adding some at $37.

Tempur Sealy International (NYSE:TPX); S&P credit rating is BB-.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 60.51

$ 12.00

$ 32.00

$ 0.05

$ 0.30

6567%

2

$ 3,940

0.06%

TPX is tied to household formations, whether it is new homeowners or new renters. But household formations are below normal and will recede further in a recession. My preference at this stage is the $32 strike which now comes at an affordable premium.

Micron Technology (NASDAQ:MU); S&P credit rating is BB-.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 34.02

$ 5.00

$ 20.00

$ 0.19

$ 0.24

6150%

3

$ 4,428

0.07%

MU is still trending upward but has a strong tendency to fall precipitously when the economy contracts. I believe that a recession would hit MU hard again. I really do believe that the target price is attainable during the next recession. Any of the strikes of $10 or higher can work. I own some at $17 but will add some at $20 this week.

Level 3 Communications (NYSE:LVLT); S&P credit rating is B.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 45.32

$ 12.00

$ 30.00

$ 0.15

$ 0.40

4400%

2

$ 3,520

0.08%

A recession or significant market swoon in the range of 30 percent would hit LVLT hard, in my opinion. The company has done a lot to improve operations and is headed in the right direction, but if a recession comes too soon management may find it difficult to maintain profitability. The stock price is still in an uptrend, but a recession could change that in dramatic fashion. I like the contracts with strikes of $25, $27 and $30 best. The $25 strike is more cost efficient using the Ask price but with the wide spread I believe we can get the $30 strike contract at or below $0.25.

Williams-Sonoma (NYSE:WSM); NR by either agency.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 70.22

$ 20.00

$ 47.00

$ 0.25

$ 0.35

7614%

2

$ 5,330

0.07%

WSM stock is trending higher but a stall in the housing market could devastate the stock again. A wide range of strikes will work. I am in at $33 and $35 so far. I plan to add more positions strikes at $47 and $57.50 this week. The $47 strike contract is much more efficient and the $57.50 contract profits will kick in quickly if a recession hits.

Marriott International (NASDAQ:MAR); S&P credit rating is BBB.

Current Price

Target Price

Strike Price

Bid Premium

Ask Premium

Poss. % Gain

# Contr.

Tot Est. $ Hedge

% Cost of Portfolio

$ 64.98

$ 24.00

$ 45.00

$ 0.10

$ 0.25

8300%

2

$ 4,150

0.05%

Finally, MAR is rising also but if travel budgets get cut due to a recession EPS will fall and the stock price along with it. Analysts and professional fund managers will anticipate this and sell early. You can get great cost efficiency all the way up to the $55 strike. I own both the $33 and $42 strike contracts and will add some at $45 this week.

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.

Source: The Time To Hedge Is Now! July 2014 Update

Additional disclosure: I own puts on all stocks listed in the article.