The Time To Hedge Is Now! April 2016 Update

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Includes: ADSK, BID, BYD, COF, CSCO, ETFC, GT, INTC, JNK, KMX, LB, LVLT, MAR, MAS, MS, MU, RCL, SIX, TPX, UAL, ZION
by: Mark Bern, CFA

Summary

Why I hedge.

Adding a new wrinkle to the strategy.

Results on recently expired and currently open positions are included in a summary table.

A brief discussion of the risks inherent to this strategy.

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, IV and X. In 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.

While I have stressed in previous articles of this series that I generally do not predict recessions or bear markets I must say that this past two years have been about more mind-boggling than I have ever seen. If you can take the time to watch this 30-minute video from SA contributor Chris Ciovacco, at about the 20-minute mark he begins to explain the cause of my frustrations. This is why I hedge. I began in 2014 by using about 1½ percent of the value of my portfolio to hedge against a potential portfolio loss of 30 percent or more. Then in year two, as I was able to capture some sizable gains from a few positions, my cost for that first year was completely offset and I found myself with gains ample enough to cover my hedging costs through year three. An inexpensive form of insurance. So, now I am basically working with house money, so to speak, and my portfolio remains fully hedged against loss. For a full accounting of the results from last year and a summary of 2014 please refer to this article.

I have implemented this hedge strategy two times before, but neither time did I fully hedge my portfolio. I was in test mode. In March 2000, I looked at the valuation of some of my stock holdings, namely Intel (NASDAQ:INTC) and Cisco (NASDAQ:CSCO), and decided that things had gotten ridiculous. I was happy for the gains but knew that holding onto those gains without doing something would not end well. I bought some puts of companies I thought would do worse in the hope that the gains from those puts would help to offset at least some of the potential losses I expected in the aforementioned holdings. I did not buy enough puts to completely cover my losses but the hedge worked and saved me from losing big. In 2008, I did not realize that things were falling apart until that spring. I tried multiple hedge strategies that time, including this one and another using ETFs. Both worked well, but this one was less expensive. At the time I was placing the hedge positions, though, everything was somewhat expensive. Again, I did not hedge my full portfolio. That was because I did not expect the crash in equities to be as bad as it was until it was nearly over.

Now, this time I began to feel that same uneasiness in the pit of my stomach in 2014. I admit that I was way too early. But we have never had so much intervention in the economy before. Referring back to the video link earlier, there have been so many technical events that have happened since early 2014 that have not happened in stocks for many decades and two that have never before happened in all of history. That has kept me feeling like it is better to be cautious than to be sorry.

There are explanations for why the market multiples are this high, such as extremely low inflation and interest rates. But for the market to warrant this valuation in the future, those conditions would need to continue also. Such conditions will not last forever and likely will begin to change (not for the better) before most investors are ready. If inflation were to fall further, it could dip into deflationary territory which could result in an even worse outcome for stocks. Thus, once again, I recommend a cautious approach to investing these days.

Most of the positions that expired in March and April did so with no value. The last time I took profits was in mid-January and I ended up with ten positions ranging in profits from 600 percent to 2,400 percent. I probably should have taken another round of profits in February but did not; coulda, woulda, shoulda. But this is insurance to hedge against a bigger loss, not a trading strategy to make big gains. I had already taken the profits last year to fund my hedging in 2016 and did not want to reduce my hedge positions until I had a good opportunity to replace those hedges. This brings me to a new wrinkle that I intend to implement going forward.

New wrinkle to the strategy

As many have noticed, I tend to buy hedge positions over time with expiration dates spread across much of the calendar year. The old dog is learning a new trick! Instead of waiting for some of my positions to expire and then trying to replace them, I have been experimenting with buying positions on new rallies to replace those contracts that will expire within the next two-three months. That leaves me slightly over-hedged temporarily, but it also provides me with the flexibility to take more gains, when they appear without exposing my portfolio to undue risk. This way I am always fully hedged and can roll positions in a fashion that is much more comfortable and in sync with the market gyrations.

My plan going forward is to increase my hedge positions in the furthest month out, but no longer than a full calendar year. I will then add hedge positions equal to about one quarter of the total I need to be fully hedged into the future months by groupings as follows: December 2016 & January 2017 is group one; March-June 2017 is group two; July-September 2017 will be group three; and October-November 2017 will be group four. To accomplish this, I may need to develop a larger position initially in January 2017, as many of the contracts in the other months do not trade early enough to fully deploy by the end of the preceding year. By the time we hit October 2016, I will probably have more than half of my positions in January 2017 and probably more than half also in group two months. I will then sell the profitable positions from group one that represent the over-hedged positions during the fourth quarter, if there is a market correction that puts me well into the black (or green, if you prefer). I will want to use the proceeds (or some of them at least) to add more positions further out into the months in groups three and four, when those options begin trading with the required minimum open interest of 50 contracts if the market rallies. By the time we get into December 2016, I will be looking to close any more profitable positions as they become so for the remaining group one months before expiration.

I hope that this does not sound too complicated. It may be for many investors. But having positions in different months over the next twelve months provides more flexibility and allows me to take more gains. Right now may not be the best time to talk about taking gains because the results of our open positions currently leave me no room to brag. But that is to be expected after such a strong rally. Is the rally over? I honestly do not know. But I do feel that sometime over the remainder of 2016, we will either be very happy that we were hedged or we will be very happy with the gains in our equity portfolio. Either way, I would rather be hedged than try to guess which way is going to make me happy. Right now it may be a toss-up, but with valuation this high, I would rather not gamble with my hard-earned savings.

Results of expired positions

Let me explain what is in the tables below. Mo/Yr. Issued represents the month during which the article that originally listed the option contract as a buy. Symbol is the ticker for the underlying stock. Strike is the strike price I list in the original article as a buy. Price @ issue means the price the underlying stock was at when the article was submitted for publication. Curr. Price is the price listed at the close of market trading on Friday, April 22, 2016. Prem. Paid is the premium listed in the original article either as the ask price, the target premium or Buy premium. Prem. @ Exp is the premium (usually zero) that the contract would have been trading at on the last day at expiration of the contract. % Gain/Loss is the percent of the original premium paid that was profit or loss (excluding commissions). Exp. Mo/Yr. is the month during which the option contract expired.

Of all the expired contracts only two, Micron Technology (NASDAQ:MU) and Morgan Stanley (NYSE:MS), had any appreciable value on the day of expiration. If you did not sell to close that position, you would have been forced to buy MU stock the following Monday to be delivered against the contract. Hopefully your broker filled the position at the opening which was $10.63. The strike price was $11. The closing price for MU on the day of expiration was $10.69. The extrinsic value should have been $31, or $0.31 per share (less commissions). Not much. If your broker bought the stock at the opening, the intrinsic value would have been $0.37 (less commissions). Either way, the commissions would have just about cleaned out what was left.

In the case of MS, though, I hope you sold your position on or before expiration to collect as much of the gain as possible. If not, the gain in the table is calculated the same way as shown for MU above.

Mo/Yr. Issued

Symbol

Strike Price

Price @ Issue

Curr. Price

Prem. Paid

Prem. @ Exp.

% Gain /Loss

Exp. Mo/Yr.

Sep/15

JNK

$35

$37.04

$35.04

$0.80

$0.00

-100%

Mar/16

Oct/5

JNK

$34

$36.30

$35.04

$1.00

$0.00

-100%

Mar/16

Oct/15

BID

$27

$34.00

$28.10

$1.15

$0.00

-100%

Apr/16

Oct/15

GT

$26

$31.82

$32.38

$1.60

$0.00

-100%

Apr16

Oct/15

KMX

$40

$59.96

$53.22

$0.75

$0.00

-100%

Apr/16

Oct/15

MAR

$65

$76.56

$66.54

$2.25

$0.00

-100%

Apr/16

Oct/15

MS

$25

$32.99

$27.70

$0.53

$0.00

-100%

Apr/16

Oct/15

MU

$11

$18.72

$10.66

$0.27

$0.31

15%

Apr/16

Oct/15

RCL

$70

$91.92

$73.80

$1.79

$0.00

-100%

Mar/16

Nov/15

ETFC

$25

$29.42

$26.14

$1.05

$0.00

-100%

Apr/16

Nov/15

$27

$33.80

$32.38

$0.70

$0.00

-100%

Apr/16

Nov/15

MS

$28

$33.98

$25.76

$0.58

$2.24

248%

Apr/16

Nov/15

UAL

$50

$58.01

$50.74

$2.10

$0.00

-100%

Mar/16

Nov/15

BYD

$17

$20.57

$20.03

$0.60

$0.00

-100%

Mar/16

Nov/15

MAS

$23

$29.84

$32.47

$0.45

$0.00

-100%

Apr/16

Mo/Yr. Issued

Symbol

Strike Price

Price @ Issue

Curr. Price

Prem. Paid

Curr. Prem.

% Gain /Loss

Exp. Mo/Yr.

Click to enlarge

Results of currently open positions

I have gains in very few of my open positions at this time. In all honesty, this is how it should look after such a strong rally. It is unfortunate and painful but I have been here before. If you notice two companies for which options are showing gains now, L Brands (NYSE:LB) and Royal Caribbean Cruises, you may recall that those two had eaten my lunch in the previous rounds. Now, even with the nice rally in the Indices, these two stocks have tumbled. That is how things usually unfold, few fall at first, then a few more, and finally the rest cave also. It is a process and this time, with all the central bank intervention going on around the world it is taking longer than usual. No one can predict when the bottom will fall out and the final stage plays out to give us the outsized gains we have been so patiently waiting for, but I am as confident as ever that it will happen eventually. As Yoda would say, "Patient, my young apprentice, we should be."

Mo/Yr. Issued

Symbol

Strike Price

Price @ Issue

Curr. Price

Prem. Paid

Curr. Prem.

% Gain /Loss

Exp. Mo/Yr.

Nov/15

RCL

$65

$94.25

$73.80

$1.41

$1.66

18%

Jun/16

Dec/15

RCL

$75

$95.90

$73.80

$1.80

$5.20

189%

Jun/16

Dec/15

MAS

$25

$27.88

$32.47

$0.80

$0.05

-94%

Jul/16

Dec/15

GT

$27

$31.87

$32.38

$0.80

$0.25

-69%

Jul/16

Dec/15

KMX

$50

$53.49

$53.22

$2.50

$2.00

-20%

Jul/16

Dec/15

ADSK

$50

$59.52

$59.54

$1.75

$1.08

-38%

Jul/16

Dec/15

SIX

$45

$52.58

$57.70

$1.25

$0.20

-84%

Jun/16

Dec/15

RCL

$75

$99.92

$73.80

$1.80

$5.20

189%

Jun/16

Dec/15

GT

$28

$32.79

$32.38

$1.25

$0.40

-68%

Jul/16

Dec/15

ADSK

$50

$61.85

$59.54

$1.80

$1.08

-40%

Jul/16

Dec/15

SIX

$45

$54.63

$57.70

$1.20

$0.20

-83%

Jun/16

Dec/15

LB

$85

$96.82

$76.76

$2.50

$8.70

248%

May/16

Dec/15

LVLT

$48

$54.40

$53.73

$1.90

$0.70

-63%

Jun/16

Dec/15

TPX

$60

$71.64

$57.33

$2.50

$4.80

92%

Jun/16

Dec/15

UAL

$50

$59.78

$50.74

$2.00

$2.24

12%

Jun/16

Dec/15

MAS

$25

$28.44

$32.47

$0.85

$0.05

-94%

Jul 2016

Dec/15

ETFC

$27

$29.71

$26.14

$1.25

$1.85

48%

Jul/16

Jan/16

COF

$60

$70.74

$75.56

$1.95

$0.21

-89%

Jun/16

Jan/16

BID

$24

$21.67

$28.10

$4.10

$0.80

-80%

Jul/16

Jan/16

BID

$20

$21.67

$28.10

$3.60

$0.95

-74%

Jan/17

Jan/16

ZION

$18

$21.78

$27.28

$0.77

$0.04

-95%

Jul/16

Jan/16

ZION

$15

$21.78

$27.28

$0.71

$0.06

-92%

Jan/17

Jan/16

ZION

$18

$22.68

$27.28

$0.58

$0.04

-93%

Jul/16

Jan/16

LB

$75

$96.15

$76.76

$2.10

$4.10

95%

Aug/16

Jan/16

SIX

$40

$50.27

$57.70

$1.05

$0.05

-95%

Jun/16

Jan/16

MAS

$22

$26.39

$32.47

$0.90

$0.05

-94%

Jul/16

Jan/16

GT

$25

$28.41

$32.38

$1.40

$0.10

-93%

Jul/16

Jan/16

COF

$55

$65.62

$75.56

$1.81

$0.11

-94%

Jun/16

Feb/16

LB

$65

$81.87

$76.76

$2.70

$1.10

-59%

Aug/16

Feb/16

MAS

$22

$25.82

$32.47

$0.80

$0.05

-94%

Jul/16

Feb/16

MAR

$55

$63.80

$66.54

$1.95

$0.40

-79%

Jul/16

Feb/16

MAR

$50

$63.80

$66.54

$1.75

$1.15

-34%

Jan/17

Feb/16

GT

$27

$29.69

$32.38

$1.20

$0.25

-79%

Jul/16

Feb/16

GT

$22

$29.69

$32.38

$0.90

$0.45

-50%

Jan/17

Feb/16

SIX

$45

$47.52

$57.70

$1.55

$0.20

-87%

Jun/16

Feb/16

SIX

$40

$47.52

$57.70

$1.10

$0.05

-95%

Jun/16

Feb/16

SIX

$40

$47.52

$57.70

$1.25

$0.55

-56%

Dec/16

Feb/16

RCL

$55

$68.77

$73.80

$2.35

$2.75

17%

Jan/17

Feb/16

UAL

$45

$48.35

$50.74

$2.00

$0.76

-62%

Jun/16

Feb/16

LVLT

$44

$46.66

$53.73

$1.75

$0.20

-89%

Jun/16

Feb/16

TPX

$50

$54.13

$57.33

$2.85

$1.10

-61%

Jun/16

Feb/16

TPX

$45

$54.13

$57.33

$2.60

$1.45

-44%

Sep/16

Mar/16

LB

$78

$87.50

$76.76

$3.25

$5.30

63%

Aug/16

Mar/16

MAS

$20

$28.99

$32.47

$0.65

$0.20

-69%

Jan/17

Mar/16

MAR

$50

$68.98

$66.54

$1.90

$1.15

-39%

Jan/17

Mar/16

GT

$25

$32.53

$32.38

$1.30

$0.80

-38%

Jan/17

Mar/16

SIX

$40

$52.56

$57.70

$1.25

$0.25

-80%

Sep/16

Mar/16

RCL

$57.50

$74.01

$73.80

$2.60

$1.19

-54%

Sep/16

Mar/16

UAL

$46

$58.00

$50.74

$1.80

$2.34

30%

Sep/16

Mar/16

LVLT

$40

$50.81

$53.73

$1.35

$0.45

-67%

Sep/16

Mar/16

TPX

$45

$61.18

$57.33

$2.00

$1.45

-28%

Sep/16

Mar/16

ZION

$18

$24.34

$27.28

$0.85

$0.33

-61%

Jan/17

Mar/16

COF

$50

$69.59

$75.56

$1.85

$0.70

-62%

Jan/17

Mar/16

BID

$20

$25.81

$28.10

$1.85

$0.95

-49%

Jan/17

Mar/16

JNK

$32

$33.81

$35.04

$1.10

$0.40

-64%

Sep/16

Month Issued

Symbol

Strike Price

Price @ Issue

Current Price

Premium Paid

Current Premium

Percent Gain/ Loss

Expiration Month

Click to enlarge

With all the negatives listed in the gain/loss column, it should be apparent that this is a good time to be adding more positions. I am already slightly over-hedged but may add a few more small positions here. Volatility is way down and the prices on many of our candidates are up enough to make for a good entry point. Since I am fully hedged but want to add some more positions to provide the flexibility I mentioned near the beginning of this article, this appears to be just about as good a time as any. To that end I plan to submit another article with my favorite positions by Monday.

Discussion of Risk

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 and different expiration months on one company. I do so because as the strike rises the hedge kicks in sooner and I also do not want all of my positions to expire at once, but I buy a mix to keep the overall cost down. I currently own positions that expire in May, June, July, August and September of 2016 as well as some that expire in January 2017. 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. Thus far I have been able to keep the cost per year under two percent, and I have been fortunate enough this past year to have ample gains to cover my hedge costs since the inception of this series and through the next year. Thus, over the full 21 months since I began writing this series, my total cost to hedge has turned out to be close to zero.

I want to discuss risk for a moment now. Obviously, if the market were to continue higher beyond January 2017, all of my option contracts that I 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 probably not be hedging. 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 expensive the insurance may become on a cumulative basis. 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 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 now. 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 own put options as a hedge against my portfolio in all the stocks listed in the article.