Seeking Alpha
Retail investor, long/short equity, dividend investing, medium-term horizon
Profile| Send Message|
( followers)  

Hedging, like buying insurance, is best done before you need it. However, simply buying it right doesn't solve all the problems. Next come questions of timing - when should the hedge be removed? Should it be removed? From there, it gets to be about strategy - what is to be done with the newly available funds?

Several weeks ago I wrote an article suggesting that it would be a good time to start hedging. Having acted on my opinion, I'm not unduly apprehensive about current market tensions. However, in the event the current downdraft does become the long awaited correction, it will be important to have a plan to derive maximum benefit from the hedges that have been put in place.

Objectives

My philosophy on hedging has evolved in a direction where I'm less concerned with preventing my portfolio from going down a certain percentage, and more concerned with having resources available to adjust my positions, or establish new ones, as market conditions dictate and as opportunities arise.

Attempts to completely insulate a portfolio from the normal ups and downs of the market can be counter-productive - too much money spent on insurance guarantees a loss. My own analysis, as well as the opinions of those I follow - Jeff Miller, Alan Brochstein and Andrew Butter - point toward a target for the S&P 500 of 1,400 and beyond. There is no point in betting against my own opinion, other than what is required to prevent excessive losses due to volatile or leveraged positions and the possible occurrence of unpredictable events.

As events in Japan and the Mideast demonstrate, unexpected developments can intervene and cast a shadow of doubt over rosy future scenarios.

Over the past few years I've developed procedures for defending and adjusting positions during difficult markets. Planning ahead can be helpful, as hectic conditions may make it difficult to think clearly under pressure, and it will be good to fall back on plans made during less stressful times. This article goes back over what has worked for me in the past, with a few new experimental ideas that I hope to work in if conditions permit.

Plan of Action

There are specific actions that can to be taken as the market declines, most of which require that funds be available. The following represent the procedures I intend to follow if the market continues its downward path:

  • Buy back covered calls. I sell out of the money calls for periods as long as six or seven months. If the price of the option is down 80% from where I sold it, I buy it back. My experience has been that I will often get a better opportunity to sell another call, for more premium.

  • Sell puts. During periods of market turbulence, volatility increases, making it attractive to harvest premiums. Often, if I have a long position by means of the money calls, I sell a put at the same strike, creating a synthetic share. Or I may sell puts with the same expiration as covered calls, creating a strangle. The stock can't go both directions at once. This does require that funds be available to support the put obligation.

  • Roll in the money calls down. As the share price declines, a long dated in the money LEAP will pick up time value, which can be harvested by rolling down. Often it is possible to pay well under 4 to roll down, and then collect more than 4 to roll back up when the stock recovers. Rolling down requires that funds be available.

  • The "peekaboo" defense. This is a new idea, and untested. As an example, I'm long Hartford Financial (NYSE:HIG) Jan 2012 22.5 calls, and short September 2011 23 puts. If assigned on the puts, the calls, which will still have 4 months to expiration, will have picked up quite a bit of time value and can be sold for salvage. The loss from the options position will be less than would have been incurred by owning the equivalent number of shares.

  • I resist the urge to double down. The preferred tactic is to retreat by rolling options positions down. Frequently high beta, smaller capitalization stocks do poorly in down markets, and that's when it's easiest to build low cost positions, patient accumulation in small lots.

Maintaining Protection

Having a hedge creates the temptation to try and call the bottom. The idea of marshaling all available resources to cash in on the expected rally is appealing. Sad experience in late 2008 and early 2009 suggests a certain amount of caution is in order. Also, after cashing in my hedges in May last year I spent an anxious summer waiting for the rally, and finally re-established the hedge just before blast-off. This is my current plan for working with my hedge positions:

  • Roll long in the money puts down. Part of my hedge consists of deep in the money, long dated puts on SPY - the December 2013 150 strike. Similar to the procedure described above for calls, when the market goes down the puts can be rolled down for a net credit. The funds liberated can be used to roll the calls down, nicely symmetrical.

  • I'm less certain about how to handle my out of the money XLF position - long the September 2011 15 puts. In the event of a serious correction, a put that was bought 11% out of the money and is now at the money will have picked up substantial time value, which should be harvested. The puts I plan to sell against volatile financials will be less risky if the hedge is maintained. The performance of individual stocks vs. the ETF hedge may determine the proper actions.

  • Review the interaction of the hedge and the positions protected. For example, it may be easy to get good premiums by selling puts on volatile financials such as HIG, Prudential (NYSE:PRU) or MetLife (NYSE:MET). These short puts could be 5% out of the money and have substantial time value. If hedged with longer dated in the money XLF puts, time is an ally.

  • Maintain a diagonal relationship between long puts (the hedge) and short puts. Long puts can be kept in the money and longer expiration, while short puts can be at or out of the money and have less time to run until expiration.

  • Consider rolling long at the money puts up. If the previously mentioned XLF September 2011 15 puts are at the money, the time value will be at a maximum. If this is harvested by rolling the puts up to a higher, in the money strike, the hedge will perform more predictably. As compensation for accepting potential loss to the upside, puts can be written against a variety of financials held in a portfolio. This would be an experiment - I think of it as the "hedge hopper" routine.

  • Wait for the all clear. If and when the market has made a definite upward move confirmed by volume, along the lines of a rally and confirmation, hedges can be adjusted and reduced to a minimum appropriate for the structure of the portfolio and the inherent uncertainty of the future.

  • Shut the door behind you. Faced with brighter prospects, it may be tempting to leave a bunch of short puts out there to expire. The temptation to save a nickel, and avoid another commission, should be resisted. Similar to calls, when the premium is 80% earned, they can be bought back. Sometimes it's not possible at a realistic price, in which case they can be left open, but not forgotten.

General Thoughts

While some of the foregoing may seem complex and counter-intuitive, if a few principles are applied consistently in developing solutions to problems as they occur, improved results will follow:

  • Sell time premium. When markets are down and volatility is high, any option that is at or close to the money will have substantial but ephemeral time value.

  • Accept downside risk. A majority of market participants are trying to minimize their exposure to further loss. Those who are willing to bear risk have an advantage in this environment.

  • Deploy funds. There is a natural urge to be protective of cash resources. If a proper cash reserve was held aside during easier times, or can be extracted from existing positions as described above, the investor should utilize the hard-won advantage provided by dry powder.

  • Gradualism. Rather than looking for that magic moment to go all in, it is better to buy and adjust in amounts that can be sustained. That way, some of the actions taken will occur at the market bottom.

These ideas worked well in the May meltdown last year. I cashed in the hedges at a profit and was well positioned when the rally finally ignited in September. If that can be replicated, the days of hiding behind the hedge will have been well spent.

Source: Hiding Behind a Hedge: Putting a Plan in Place for Today's Market

Additional disclosure: I'm short SPY and XLF as described in the article. I'm net long MET, HIG, and PRU and anticipate selling puts on a variety of U.S. equity positions in the event a correction materializes.