4 Inflation Hedges for 2011

Includes: C, DBA, DBC, ENP, XHB, XLE, XLF
by: Philip Davis

I hope you got everything you wanted this holiday season and, most importantly, I hope you had time to spend with your family. I’m waiting for mine to wake up – waiting for my children to come out of their rooms so I can videotape (gosh I’m old, there’s no tape anymore) them in those first moments of Christmas morning. How can I not be of good cheer anticipating that?

It occurred to me, though, that I have something I can give you. Not peace on earth but perhaps peace of mind heading into the New Year – a way to help insure some future prosperity with a few inflation-fighting stock picks that can brighten up your portfolio, which also can be used to help balance the budget against unexpected cost increases.

This isn’t an options seminar or one about risk or leverage. These are just a few practical ideas you can use to hedge against inflation as it may affect your everyday life. Using basic industry ETFs and some simple hedging strategies these will give you an opportunity to stay ahead of the markets if they keep going higher.

Idea #1 – Hedging for Home Price Inflation

Let’s say you have $20,000 put aside for a deposit on a home but you’re not sure it’s the right time to buy. On the other hand, let’s say you are worried that home prices will take off again (I doubt this but you never know). XHB is the homebuilder’s ETF, currently at $17.46. Homebuilders bottomed out at $7.77 in 2009 and were in the $40s back in 2006.

You can sell 20 contracts of the XHB 2013 $14 puts for $1.70 each ($3,400) and that obligates you to buy 2,000 shares of XHB at $14 (20% off the current price). You can use that money to buy 30 2013 $15/18 bull call spreads for $1.40 ($4,200)- so another $800 out of pocket and you have 30 $3 contracts for net $800 that pay back $9,000 if XHB simply gains .54 by January 2013. These bull call spreads, however, do not pay off early: The ETF needs to be above $18 on the January 2013 options expiration day (the 18th).

So you are putting up $800 in cash and the margin requirement on the sale will be roughly $7,000 (1/2 of the potentially put price) in an ordinary margin account. What have we accomplished? Well, if XHB goes up, your $800 becomes $9,000, adding $8,200 (41%) to your $20,000 deposit. That should keep you up with up to a 40% jump in home price. But if they go up that fast, getting a deposit will be the least of your problems!

On the risk side. We certainly don’t expect XHB to go to zero but let’s say it falls to $7 (worse than the last crash). Well, you are obligated to own 2,000 shares at $14 ($28,000) and you would have lost half. So $14,000 is your risk there, but I would put it to you that if we have a crash of that magnitude again, you are better off losing that $14,000 than if you had bought a home for $250,000 and had it drop 20% on you ($50,000) or even 10% ($25,000). Again, that’s a very extreme example and you are not locked into the trade. You can get out when the loss is $5,000, for example, keeping 75% of your deposit and feeling good about waiting out a declining market.

That’s what hedging is, it gives you a cushion that can prevent things from getting away from you. For example, you can hedge this hedge by buying 20 2013 $10 puts for .70 ($1,400). You cap your downside at $10 ($8,000 loss) but you raise your outlay to $2,200 and lower your reward potential to a still respectable $6,800 (34%). Just an example of a way to control the downside.

You can trigger a cover like that only if XHB fails to hold, for example $15. You can actually work these swings to your advantage by adjusting the trade as the stock moves through a channel but, for the sake of simplicity – we’re just discussing passive risk management examples. The idea is to reduce your risk of waiting – that lets you sit back and make an intelligent, well-timed decision without worrying that the market is getting away from you. Unlike CDs or bonds, there is no penalty for an early withdrawal from a hedge, other than the bid/ask spread you may pay if you do it very quickly.

Idea #2 – Hedging for Fuel Inflation

Gasoline prices are once again creeping up and, if you are the average family, you buy about 1,000 gallons of gas per year ($2,500) and spend another $1,500 heating your home. That’s $4,000 a year spent on energy and it’s already up over $1,000 from last year – pretty annoying, right?

XLE is the ETF for the energy market and it’s currently trading at $67.41. If you want to guard against another $1,000 increase in the price of fuel next year you can, very simply, buy two January 2012 $55/60 bull call spreads for $2.60 ($520) and offset that cost with the sale of one 2013 $50 put for $4 ($400), for a total outlay of $120. If XLE simply maintains $60 for the year (11% lower), you make $880 (733%).

We can assume any increase in fuel prices over the year will push them higher and XLE has pretty much held $55 all year and oil was below $60 (down 30%) last time it was below $75 in August. So this is a very nice mechanism for hedging 20% of your fuel cost. What’s nice about this is oil can fall and you’ll save money on your fuel. And as long as XLE doesn’t fall more than 25% by 2013 – the trade only costs your $120 cash outlay. You should save far more than that on lower energy prices (assuming that relationship is maintained, of course).

Below 25%, you get assigned 100 shares of XLE at $50 in 2013. That’s a price that’s held up very well since the end of April ’09, when oil was under $50. So a risk of owning $5,000 worth of the Energy Spider, which puts you bullish on oil over $50. That will always make a nice long-term hedge against inflation.

Now our members know they can roll those puts or convert those put assignments into buy/writes or do a dozen other things to mitigate the losses. As I said, these are really basic examples of how anyone can hedge their real-life budgets to help them make long-range plans to fight inflation. Actually, I just followed the link and, oddly enough, the example trade there is an energy trade. It was ENP, which is another good way to play. That stock was picked at $16.50 earlier this year and we hedged it down to $14 and it’s now $21.77! Not bad for a free sample…

Our other free sample was Citigroup (NYSE:C) with a net .78 entry on the January 2011 $2.50/5 bull call spread for net .78. That one is now $2.18 in the money with a few weeks to go. So up a lovely 179% in less than a year – another good way to keep ahead of inflation! I suggest checking back there once in a while as it’s time for me to update our trade examples. Who knows what the next two picks may bring?

Idea #3 – Hedging for Food Inflation

If you think you spend a lot on fuel, maybe you haven’t been to the grocery store lately. I knew food inflation was getting out of hand when the A&P’s fruit and vegetable prices started catching up with Whole Foods (WFMI). I used to get a few cool items at Whole Foods and stop at A&P for the staples but there’s barely a difference in fruits and vegetables anymore when it used to be extreme. Good for Whole Foods and local growers but not so good for the average consumer who is being bled dry by commodity speculators and agriculture cartels.

And the middle-men are getting crushed too. A&P (GAP) is filing for bankruptcy and Dean Foods (NYSE:DF) is the year’s worst performer on the Russell 1,000 while WFMI is one of the best. So it pays to grow the food and it pays to sell the food to the top 10% but it’s not so good to be in between the two! This is completely in-line with our "Tale of Two Economies" outlook for 2010.

Perhaps the CEO of Dean Foods, then, can benefit from this hedging exercise as well.

DBA is the way to go here. We’ve had many DBA trades this year and some 2012 spreads are still running and way back on 2/28, I had even mentioned the January 2011 $21/23 bull call spread in a Weekly Wrap-Up that obviously has its 100% in the bag already. The more conservative buy/write play is up "just" the 20% max and, unfortunately, not keeping up with the price of many foods, not to mention cotton, which is up 40% since March. Fortunately, we got more bullish with the March 11th picks, which were right in the morning post. We picked the January $22 calls for $3.95 (now $11, up 175%) and we added DBC (which includes energy and metals in addition to food) 2011 $15 calls at $6.10, now $12.20, up a neat 100%. Now THAT’s how we stay ahead of inflation!

It’s a little trickier now because I thought DBA and DBC were underpriced to inflation in March so we took some very aggressive positions. Since then, Obama and the Bernank have dropped another $2 trillion on the economy. So we’ll have to hold our nose and pick a position, but one that’s not quite so gung-ho bullish as the last two.

While DBA is a bit pricey at $32, we know we loved it at $20. So selling the 2013 $25 puts for $1.90 is a net $23 entry and we feel we can live with that. If you spend $10,000 a year on groceries you can risk being assigned 400 shares for $9,200 and sell four of the puts for $760. That money can be used to buy six of the 2012 $26/29 bull call spreads for $1.90 ($1,140) and that’s net $380 out of pocket (two weeks' shopping). The upside? If DBA simply holds $29 (down 10%) then $1,800 less the $380 laid out is $1,420. So a 14.2% hedge against food inflation that pays you even if it’s actually down 10%. You don’t lose any money until DBA is down around $26.50, at which point, you food savings should well cover the $380 you spend on the 2012 spread.

The 2013 put sale; if DBA should go down all the way to $21 (down 33%), that would cost you $1,200 – also a lot less than you will probably save on food. Remember, these are not magic beans that pay off no matter what the market does – these are hedges against inflation. If there is no inflation, then you will save LESS than you otherwise would have. But, again, there are dozens of ways to make owning DBA long-term a successful part of your portfolio. Instead of randomly investing your retirement savings, trade ideas like these are ways to put some of the money to work for you. These are ways that can help you manage your bills NOW, as part of your daily life.

Inflation Hedge #4 – A hedge against Fed-based inflation

How about using my favorite hedge to hedge against general inflation? See here for more details. The trade is VERY simple: The XLF January 2012 $12/13 bull call spread for .80, selling the 2012 January $11 puts for .40. That will be net .40 on the $1 spread (we are not counting the margin amount, which is about $150 per contract, just the cash outlay). The upside is if XLF reaches expiration at $13 (now $15.87) that is 150% of that .40. So the net price of that spread has to be .80 or greater – that’s the "bet." Obviously, if the net of the spread is even a penny, the $11 puts would expire worthless and will not be an issue. This is not really an inflation hedge other than general market inflation caused by the Fed feeding endless amounts of money to – the Financials! See my logic on this one?

I very much hope all these trades work out well, ESPECIALLY the last one!

Have a very happy holiday and we hope to see you inside in the new year.