The Time To Hedge Is Now! Rolling Many Smaller Gains Of Up To 1400%

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Includes: BID, KMX, MAR, MS, MU, STX, VECO, WSM
by: Mark Bern, CFA

Summary

Overview of strategy series and why I hedge.

The last profits I plan to take on positions that expire this Friday, January 15.

What I will do with the rest of my open positions that expire Friday.

An example of how I will roll some of these positions.

Discussion of risk involved in the hedge strategy.

Hedge Before I get into the overview section I just want to emphasize once again that even though I am taking some great gains off the table as we sell positions that expire on Friday January 15, 2016, this is not a get rich quick scheme. I am simply buying some insurance to hedge against losses to my equity portfolio. Many of my stock holdings have taken a beating in 2015 as I am sure at least some of you have experienced as well. So far stocks have not crashed and the indices are only down a few percentage points. I did very well in 2015 but suspect that hedging will be even more important in 2016.

Strategy Overview

If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this Instablog. It may be more difficult to follow the logic without reading Parts I, II and IV. 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 contemplation regarding possible triggers that could lead to another sizable market correction.

I want to make it very clear that I am NOT predicting a market crash. I merely 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! However, I will say that I expect 2016 to be a more trying year than 2015. I cover my reason why an article about the general economy which I will link to as soon as it is published.

Why I Hedge

If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain, both financial and emotional. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while) I only need a gain of 25 percent to get back to even. That is much easier to accomplish than doubling a portfolio and takes less time. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles.

I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market, in my humble opinion. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the "dip" evolves into a full blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells when they should be getting ready to buy.

The last profits I plan to take on positions that expire in January

Briefly, I want to review the positions I have already sold and where those same positions stand today for those who may have missed my earlier sell recommendations. All of these option contracts expire on January 15, 2016 (this Friday). All current quotes are as of Friday, January 8, 2015 close. If you still hold any of these positions:

  1. First, bravo! You have outsmarted me and done better than I have.
  2. Sell them this week before Friday so that you will not need to pay the extra cost of executing the options, buying the stock and then selling the stock just to capture your gains. Selling now will be much easier and much less expensive.

Symbol

Month Purchased

Strike Price

Current Sh. Price

Prem. Pd.

Rec. Sell Prem.

Current Prem.

Current Gain

MU

Apr 2015

$20

$13.33

$0.49

$5.45

$6.40

1,206%

MU

May 2015

$18

$13.33

$0.33

$3.45

$4.30

1,203%

BID

May 2015

$35

$21.67

$0.90

$8.00

$12.50

1,289%

BID

Jun 2015

$35

$21.67

$0.50

$8.00

$12.50

2,400%

BID

Aug 2015

$31

$21.67

$0.55

$4.10

$8.60

1,464%

STX

Apr 2015

$38

$32.54

$0.58

$3.90

$4.85

736%

WSM

Jun 2015

$70

$54.67

$1.90

$10.90

$13.30

600%

WSM

Aug 2015

$72.50

$54.67

$1.80

$12.30

$15.80

778%

WSM

Aug 2015

$70

$54.67

$1.90

$10.90

$13.30

600%

MW

Aug 2015

$45

$12.09

$0.75

$29.90

$31.40

4,087%

Click to enlarge

Micron Technology (NASDAQ:MU), Sotheby's (NYSE:BID), Seagate Technologies (NASDAQ:STX), Williams-Sonoma (NYSE:WSM) and Men's Warehouse (MW) have been good to me in 2015 and some have given me even more gains in my remaining positions yet to be sold that I list shortly.

There were ten great wins in that list above that will help me cover my cost of hedging in 2016. But there are even more on the list of positions that remain open. I intend to take profits on all of the positions listed below that I own. I did not buy every position recommended in all of the update articles written in 2015. That would have been overkill. I missed some good ones but was fortunate enough to have bought the best positions. I usually start a position with about one-third of what I need to own to protect my portfolio then add only when I can buy either the same strike at a lower premium or a higher strike at a similar or lower premium. In other words, I am always trying to improve my position as I add new positions.

The list below contains all open positions that had gains as of the Friday, January 8, 2015 closing prices. Included in the list of winners are Micron Technologies, Williams-Sonoma, CarMax (NYSE:KMX), Sotheby's, Morgan Stanley (NYSE:MS), Veeco (NASDAQ:VECO), Marriott (NYSE:MAR), and Seagate Technologies.

Symbol

Month Purchased

Strike Price

Current Sh. Price

Prem. Pd.

Current Prem.

Current % Gain

MU

Dec 2014

$17.00

$13.33

$0.60

$3.60

500%

MU

Jan 2015

$17.00

$13.33

$0.59

$3.60

510%

MU

Mar 2015

$17.00

$13.33

$0.40

$3.60

550%

MU

Jun 2015

$15.00

$13.33

$0.47

$1.60

240%

WSM

Mar 2015

$60.00

$54.67

$1.65

$4.90

197%

WSM

Apr 2015

$60.00

$54.67

$1.85

$4.90

165%

WSM

May 2015

$60.00

$54.67

$1.25

$4.90

290%

KMX

Apr 2015

$55.00

$46.80

$1.85

$8.10

338%

KMX

May 2015

$55.00

$46.80

$1.40

$8.10

479%

KMX

Jun 2015

$57.50

$46.80

$1.80

$10.50

483%

KMS

Aug 2015

$55.00

$46.80

$3.10

$8.10

161%

KMX

Sep 2015

$50.00

$46.80

$1.80

$3.00

67%

MS

May 2015

$28.00

$28.38

$0.44

$0.50

14%

MS

Jun 2015

$34.00

$28.38

$0.92

$5.05

449%

MS

Aug 2015

$35.00

$28.38

$0.96

$6.05

530%

BID

Apr 2015

$30.00

$21.67

$0.50

$7.50

1,400%

BID

Aug 2015

$30.00

$21.67

$1.05

$7.50

614%

STX

May 2015

$35.00

$32.54

$0.43

$2.00

365%

STX

Jun 2015

$35.00

$32.54

$0.52

$2.00

285%

VECO

May 2015

$20.00

$17.20

$0.90

$2.25

150%

VECO

Jun 2015

$20.00

$17.20

$0.40

$2.25

463%

MAR

Jun 2015

$65.00

$62.65

$1.75

$2.50

43%

Click to enlarge

Some have done well and others not so much. I still hold over half of these positions and will sell on the early this week. I suggest that readers who may hold these positions consider selling also as soon as possible. Any extrinsic value that remains will disappear quickly and holding until the last day can turn into being forced to allow the contract to be executed which only leads to more commission for your broker. I do not hold on for that last nickel any more. I have in the past and have found it is not worth it most of the time. If you expect more down days in the coming week and are braver than I am you may pick a few more nickels. But, unless these stocks fall significantly you are just trying to pick up nickels in front of a steam roller. It could rally and take every nickel back and then some.

What I will do with the rest of my open positions

The following positions are trading at a loss but could still allow me to recapture some of my initial investment. I plan to place a bid to sell all of these positions about five to ten cents above the bid price in hopes of getting more than the cost of commissions back from the trade. I will only use limit orders in selling and try to get orders filled near the midpoint between the bid and ask premiums. The premiums listed below in the "current premium" column are the limit prices I intend to place. You can adjust to what makes sense to you, a little higher or a little lower, depending on how the market opens on Monday. As I look at market action in Chinese market as I write this article, Monday exchanges there are down anywhere from 2.4% to 3.5%, so I expect a lower opening on European Bourses and in the U.S. We will see.

Symbol

Month Purchased

Strike Price

Current Sh. Price

Prem. Pd.

Current Prem.

Current % Loss

WSM

Jan 2015

$55.00

$54.67

$1.90

$1.15

-39%

WSM

Jan 2015

$55.00

$54.67

$1.60

$1.15

-28%

LB

Apr 2015

$65.50

$93.23

$1.10

$0.10

-91%

LB

May 2015

$70.50

$93.23

$1.85

$0.10

-95%

LB

Jun 2015

$72.00

$93.23

$1.45

$0.15

-90%

LB

Aug 2015

$70.00

$93.23

$2.20

$0.10

-90%

LB

Sep 2015

$78.00

$93.23

$1.80

$0.20

-89%

MAR

Apr 2015

$55.00

$62.65

$0.80

$0.10

-88%

MAR

Aug 2015

$62.50

$62.65

$1.45

$1.00

-31%

MAR

Aug 2015

$60.00

$62.65

$1.75

$0.30

-83%

MAR

Sep 2015

$62.50

$62.65

$1.75

$1.00

-43%

LVLT

May 2015

$42.00

$49.95

$0.90

$0.20

-78%

LVLT

Jun 2015

$42.00

$49.95

$0.90

$0.20

-78%

JBL

May 2015

$18.00

$19.84

$0.40

$0.15

-63%

ETFC

Jun 2015

$25.00

$26.71

$0.84

$0.18

-79%

TPX

Aug 2015

$60.00

$64.17

$1.70

$0.30

-82%

TPX

Sep 2015

$60.00

$64.17

$1.60

$0.30

-81%

MAS

Aug 2015

$25.00

$25.53

$0.40

$0.25

-38%

MS

Aug 2015

$28.00

$28.38

$0.71

$0.50

-30%

MS

Sep 2015

$27.00

$28.38

$0.62

$0.23

-63%

CCE

Aug 2015

$45.00

$46.48

$1.06

$0.15

-86%

UAL

Sep 2015

$45.00

$51.89

$1.39

$0.11

-92%

Click to enlarge

I may not get fills on all of the positions I hold at these premiums, but if the market opens lower I should get most. If any of the stocks open significantly lower I will adjust my limit order price upward to reflect my good fortune. The losses are what I consider the cost of my hedge, or insurance, against catastrophic losses. Any other positions that are not listed I intend to allow to expire worthless unless the market takes a nosedive next week again. Anything is possible and I may end up collecting more than I expect, or less. In any event, it has been a good year any way I slice it.

An Example of how I will roll some of these positions

BID has fallen nicely but I believe that the decent has much more to go. My original target price was $16 but in reviewing the weakness of the stock and the Chinese economy I now expect BID to go even lower when it is all over. My new target is $10. When I look at the chart below of how the BID share price collapsed to below the $10 level in both 2003 and 2009, I believe the situation today is similar.

BID Chart

BID data by YCharts

As the boom source of Chinese bids dry up, and they are just like sources of the dot com boom bids in early 2000s and the U.S. housing boom bids in 2008-09, the sales and margins will both contract taking the share price down the well hole again. This time there is a small, but growing, online collectibles auction that is skimming much of the higher margin, low priced pieces away from the old guard. That just adds fuel to the fire. We can even go all the way back to 1989 when the same thing happened to BID shares as the bids from Japan dried up. It just happens after every major boom comes back to earth and that is where I believe we are headed in 2016.

Here is what I intend to do with the gains taken from selling my January expiration BID contracts. I bought three Bid put option contracts in April and three more in August, all with $30 strikes. My cost was a total of $150 in April and $315 in August (plus commissions) for a total of $465. As I sell these contracts this week I should be able to get the prices I have listed in the table earlier or better which will result in my collecting $4,500 (less commissions), or 6 contracts at $750 apiece. The gain is $4,035, which is less than I needed to protect 1/8 of a $200,000 portfolio (assuming two positions equals protection for double the usual $100,000 portfolio I usually use) against a loss of 30 percent or more. I need to set up a position that can provide me with approximately $3,500 more protection for my strategy to work with BID. I also need that position to cost less than the $4,500 in proceeds that I am collecting from the original two positions. So, here is the new position I plan to take with BID when the market finds its feet. I tentatively intend to create one of two positions, hopefully on Monday or, if the BID share price rises later in the week I will initiate the positions then. I will also continue to watch for opportunities to improve my position in the future. Here are the details on what I plan to do.

Expiration Month

Current Price

Target Price

Strike Price

Ask Prem.

Bid Prem.

Target Prem.

Poss. % Gain

Total Est. $ Hedge

July 2016

$21.67

$10

$24

$3.70

$4.10

$4.10

241%

$3,960

Jan 2017

$21.67

$10

$20

$2.45

$3.60

$3.60

178%

$3,840

Click to enlarge

Either position would provide the additional protection needed. For the protection indicated above for the July 2016 position I would require four contracts at a total cost of $1,640. The January 2017 position would require six contracts at a total cost of $2,160. I prefer the July position because of the lower cost. And, of course, there are other strikes that would offer a better percentage gain potential in the July contracts but I want to give this one plenty of time or stick with the higher strike. It is a tradeoff we all need to make. If the price rises between now and expiration these positions could expire worthless. So I plan on doing one or the other, using only a portion of the previous gain and hold the rest in reserve in case a better opportunity arises.

If you would like more examples of what I plan to do with the remaining gains as I roll forward please leave a comment and I will try to include those plans in my next installment soon. Generally speaking, market rarely go straight up or straight down. Thus, I believe we may very well have an opportunity to initiated new hedge positions in the coming weeks at better prices than are available today. I plan to write about each one as it arises.

Discussion of risk involved in this hedge strategy

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. To accomplish this I generally add new positions at the new strikes over time, especially when the stock is near its recent high. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this may represent the last (or next to last) time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent.

I want to discuss risk for a moment now. Obviously, if the market were to move higher from the level from which we enter positions beyond the expiration of option contracts that we own or open in the future any or all could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. 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. I have already begun to initiate another round of put options for expiration later in 2016 using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for part of another year. The longer the bulls maintain control of the market the more the insurance is likely to 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 before the next recession occurs 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 two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three 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 before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like five 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, at this point I would expect the next bear market to be more like the last two, especially if the market were to make new highs later in 2016. Anything is possible but 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.

For those interested in learning more about my investment philosophy you can find more detail in a series of articles titled, "How I created my own portfolio over a lifetime." For those who prefer to listen rather than read I was interviewed by Brian Bain, of Investor in the Family, about my investment philosophy and you can listen to the podcast here.

Disclosure: I/we 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 in all but MW of the stocks listed in this article.