Put Options: Inferring Investment Ideas From A Self-Made Billionaire

 |  Includes: AXP, DIA, DIS, IAU, MMM, NVO, SLV, TM, TOT
by: David Pinsen

From A $700 Investment To A Billion-Dollar Business

The January issue of Private Wealth carried a compelling feature from Bloomberg News ("In The Eyes of Business Tycoons"). In it, Bloomberg reporters Matthew Biller and Peter Newcomb asked several billionaires what was the best investment advice they had received, and also how they would allocate a $1 million portfolio today. One of the billionaires they profiled was Los Angeles-based entrepreneur John Paul DeJoria, who invested $700 dollars in a friend's hair care business thirty years ago and helped build it into the billion dollar business it is today (Paul Mitchell).

How DeJoria Would Allocate A $1 Million Portfolio

In response to the question about positioning a $1 million portfolio, DeJoria offered this allocation:

  • 25% in gold

  • 25% in silver

  • 25% in Asian and European blue chips that pay dividends

  • 25% in NYSE blue chips that pay dividends

DeJoria didn't list specific securities, but I put together a basket of names that fit his criteria. For the gold and silver allocation, I used widely-traded ETFs that track the respective metals, and for the Asian, European, and NYSE blue chips, I found half a dozen large cap dividend-payers, each in a different industry, that were rated "buy" by VectorVest (recall that VectorVest bases its recommendations on a weighted average of its proprietary relative value, safety, and timing rankings). The components of this basket are listed in the table below, but first let's consider DeJoria's investment advice and how it might be incorporated into his suggested asset allocation.

DeJoria's Investment Advice

The best investment advice DeJoria said he had received was "how to buy a put". It would have been interesting to read how, exactly, DeJoria incorporated buying puts into his investing, but the profile of him in Private Wealth didn't drill down to that level of detail. So here I will speculate based on the asset allocation DeJoria suggested.

Incorporating DeJoria's Advice Into His Suggested Allocation

DeJoria's suggested asset allocation is reminiscent of the permanent portfolio concept, developed by Harry Browne. There have been variations of the concept over the years, but a typical version of a permanent portfolio might consist of an allocation such as this:

  • 25% Stocks

  • 25% Gold

  • 25% Treasury Bonds

  • 25% Cash

Note the similarities between DeJoria's suggested asset allocation and a typical permanent portfolio, in that both are broken into four equal parts and both include allocations to gold as well as equities. The central idea of a permanent portfolio is that at least one component of it should outperform in any economic environment, making up for the underperformance of the other components. I suspect similar thinking is behind DeJoria's suggested portfolio allocation as well.

A common approach with permanent portfolios is to rebalance them on a periodic basis. Assuming DeJoria would want to maintain an equal 25% allocation to each asset class he suggested, that would require a periodic rebalancing as well. Rebalancing enables an investor to sell a portion of an appreciated asset and use the proceeds to buy more of assets that have recently declined. This is essentially a strategy of selling high and buying low. And buying puts as an opportunistic hedge, when it's relatively inexpensive to do so, can complement it.

An article in a previous issue of Private Wealth offered an example of how buying puts opportunistically enabled another billionaire to sell high and buy low, acquiring assets after they had recently declined. In last May's issue of the magazine, David Cohen, whose family office manages the wealth of another Los Angeles-based billionaire entrepreneur, explained how his firm's opportunistic buying of put options enabled it to limit his client's downside during the 2008 crash and create cash with which he could buy undervalued assets:

The large profits from this trade [purchasing put options when they were inexpensive, and selling them after the crash] helped to insulate the portfolio from a massive down stroke in 2008, and provide liquidity, which set us up for a big recovery in 2009.

The Cost of Adding Puts To Securities Fitting DeJoria's Allocation

I noted above how I put together a basket of securities that fit the allocation suggested by DeJoria. The table below shows the costs, as of Friday afternoon, of hedging the components of this basket against greater-than-20% declines over the next several months, by buying optimal puts.

A Comparison

For comparison purposes, I've also added the costs of buying optimal puts to hedge the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) against the same decline. First, a reminder about what optimal puts are, and a note about decline thresholds. Then, a screen capture showing the optimal puts to hedge a $250,000 allocation to gold, using the iShares Comex Gold Trust ETF (NYSEARCA:IAU) as a proxy.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" is the maximum decline you are willing to risk. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I've used 20% decline thresholds for all of the names below.

The Optimal Puts To Hedge $250k In Gold

As we noted above, we're using the iShares Comex Gold Trust ETF as a proxy for gold. Intra-day Friday, IAU traded at $16.91, so 14,784 shares represented $250,000 (16.91 x 14,784 = 250,000). Recall that DeJoria had suggested allocating 25% of a $1,000,000 to gold, so that's why we've used $250,000 here. Below is a screen capture showing the optimal put option contracts to buy to hedge 14,784 shares of IAU against a greater-than-20% drop between now and July 20th. A note about these optimal put options and their cost: To be conservative, we calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a slightly lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).

Click to enlarge

Hedging Costs As Of Friday

The hedging costs below are as of intra-day Friday and are presented as percentages of position value. All of the securities in the table below, including the three ETFs, were rated "buy" by VectorVest.



Cost of Protection (as % of position value)

Gold ETF


iShares Comex Gold Trust


Silver ETF
SLV iShares Silver Trust 4.98%*
Asia and Europe Stocks
TM Toyota Motor Company 1.20%*
NVO Novo Nordisk AS 3.18%***
TOT Total SA 2.98%**
NYSE Stocks
MMM 3M Company 1.48%*
DIS Disney 2.13%*
AXP American Express 2.13%*
Comparison ETF
DIA SPDR DJIA 1.86%***
Click to enlarge

*Based on optimal puts expiring in July

**Based on optimal puts expiring in August

***Based on optimal puts expiring in September

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.