The Time To Hedge Is Now! Counter Trend Rally Provides Better Entry Prices

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Includes: COF, GT, LB, MAS, SIX, ZION
by: Mark Bern, CFA

Summary

Brief overview of the series and why I hedge.

My current list of favorite candidates.

Discussion of the risks inherent to this strategy.

I would like to begin this article with links to a previous article in the series that provided results from my options that expired this past January and the recent update on positions still held here.

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 sizeable market correction.

I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. 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.

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. 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 than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing.

I recommend caution in investing going forward in 2016. We may not have seen the worst this year will have to offer. There are three charts that should be monitored that may give investors a clue as to what to expect according to this article from BlackRockBlog.com. I differ on the interpretation part but still think that the charts are eye openers. I also consider the price of copper, durable goods orders from the Commerce Department, and the Dow Jones Transportation Index (^DJT) to be good leading indicators. None of those charts are very encouraging.

I believe that what we are currently witnessing is a counter-trend rally in the early stage of a bear market. We have had a discernible lower high and a discernible lower low that define the major trend. The market could rebound to new highs, but I believe that the probability of that happening from here is much lower than continuing the trend lower. Once this rally is over I expect to see another lower high and lower low to confirm the trend.

My favorite candidates now

All quotes are as of after the close on Wednesday, January 28, 2016. I want to start with a better entry point for Zions Bancorporation (NASDAQ:ZION) since my recent article published just last Thursday. I should also begin by pointing out that if the rally continues, which it could, there will be even better entry opportunities.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$22.68

$5.00

$18.00

$0.53

$0.58

2141

$3,726

0.174%

Jul/2016

I need three ZION July 2016 put option contracts as described above to provide the coverage indicated above for a $100,000 portfolio.

L Brands (NYSE:LB)

I know LB had a great Q4 but remain convinced that it will suffer if the economy enters a recession as it has in the past.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$96.15

$30.00

$75.00

$1.85

$2.10

3,082

$4,290

0.210%

Aug/2016

I need to buy only one LB put option contract to provide the protection indicated above for a $100,000 portfolio.

Six Flags (NYSE:SIX)

This may be my favorite candidate at this time. We are in the off season for amusement parks which is often a weak period. If the economy falls into a recession by spring, this one should tank hard in Q2 2016.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$50.27

$20.00

$40.00

$0.70

$1.05

1,805

$3,790

0.210%

Jun/2016

I need two SIX put option contracts as described in the table above to provide the indicated protection on $100,000 of an equity portfolio.

Masco (NYSE:MAS)

A recession will depress home sales which should take the MAS share price down to my target price.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$26.39

$10.00

$22.00

$0.65

$0.90

1,233

$3,330

0.270%

Jul/2016

I need to buy three MAS put option contracts as described above to provide the indicated protection on a $100,000 equity portfolio.

Goodyear Tire & Rubber (NASDAQ:GT)

I believe that we have seen the peak in auto sales in the U.S. so sales to automakers should swoon in 2016. If a recession hits as I expect, GT shares will suffer as sales could fall significantly.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$28.41

$8.00

$25.00

$1.30

$1.40

1,114

$3,120

0.280%

Jul/2016

I need two GT put option contracts as described in the table above to provide the indicated protection on a $100,000 equity portfolio.

Capital One Financial (NYSE:COF)

As I outlined in my article in which I introduced COF I expect shares to suffer from rising default rates on credit card debt that I expect to happen this year. We have had better entry opportunities right after I published that article but then COF shares sold off. This rally may be the last chance to get into this one.

Current Price

Target Price

Strike Price

Bid Prem

Ask Prem

Poss. % Gain

Tot Est. $ Hedge

% Cost of Portfolio

Expiration Mo./Yr.

$65.62

$25.00

$55.00

$1.53

$1.81

1,557

$2,819

0.181%

Jun/2016

I will need to buy only one COF put option contract as listed above to provide the indicated protection for a $100,000 equity portfolio against a 30 percent drop in the major indices.

Brief Discussion of Risks

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 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. 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 21 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 turn back higher beyond January 2017 all of our option contracts that we have open 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. The longer it is before the next recession 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 whether the market will turn into a full blown bear or regain the high ground 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. 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, since the market has, in my opinion, defied gravity until 2016. Anything is possible but if I am right, protecting a portfolio becomes ever more important.

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 who would like to learn more about my investment philosophy please consider reading "How I Created My Own Portfolio Over a Lifetime, or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com which can be found 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 either own or will buy put option in all the candidates listed in this article.