The Time To Hedge Is Now! April Update - Part II

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Includes: BYD, COF, GT, JNK, LVLT, MAS, SIX, ZION
by: Mark Bern, CFA

Summary

Why I hedge.

Do not chase the new positions! Take what the market will give us.

A brief discussion of the risks inherent to this strategy.

Click to enlarge

I hope that my articles provide the above to some investors who feel they need it!

Back to Part I

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 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 have stressed in previous articles of this series that I generally do not predict recessions or bear markets. Recessions and market corrections are just part of the investing experience. They occur when we least expect them. This is why I hedge. I began in 2014 by using about 1 ½ percent of the value of my portfolio to hedge against a potential portfolio loss of 30 percent or more. Then, as I was able to capture some sizable gains from a few positions, my cost for that first year was reduced to less than one percent of my portfolio. It amounts to an inexpensive form of insurance and provides me with peace of mind. Last year my gains were much more significant and I was able to offset all of my hedging cost for 2015, the remaining costs from 2014 and have plenty left over to extend my hedge well into 2016. 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 and 2015 please refer to this article.

List of New Candidates

The list below includes one option contract for each candidate that I like from here. It also lists the premium at which I would like to own the contract(s) as well as the recent bid and ask premium, the number of contracts needed to protect 1/8 of each $100,000 in equity portfolio against a loss of 30% or more in the broader market. What I mean is that I own at least eight positions with the number of contracts listed for every $100,000 in value of the equity portion of my portfolio. I aim for coverage of about $3,750 for each position. That amount is equal to 1/8 of $30,000. If the market falls by 30 percent I want to protect against the loss of $30,000 for each $100,000 of value in my portfolio. The table also includes strike price, the percent of expected gain if the target price is hit, the target premium for each candidate and the percent of cost for each $100,000 of equity value represented by each position. The JNK options should be used only to protect the bond portion of one's portfolio. If non-investment grade bonds fall later this year, which I expect will happen, this position is designed to protect against losses to the high-yield portion of a bond portfolio. All bonds are not likely to be affected so this is meant to hedge against bad decisions by fund managers reaching for yield also. Additionally, a move in bonds is unlikely to be as great as a move in equities unless interest rates rise dramatically. Thus, this one positions may provide ample protection for a bond portfolio with a mixture of funds and/or a group of bonds with varying grades of credit ratings. All prices and quotes are as of the market close on Friday, April 22, 2016).

My first candidate is SPDR Barclay's High Yield Bond ETF JNK.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$35.04

$28

$33

$1.05

$1.30

$1.15

10

335

1.12

Jan/17

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I need 10 contracts as described above to protect a $100,000 portfolio of bonds against a loss of approximately $3,850 at a cost of $1,150 (plus commissions). It is difficult to determine how many contracts to use without understanding the mix of bonds in a portfolio. I cannot give individual advice, but this position is meant to reduce the risk exposure in the event of a junk bond rout. The cost ratio is not as good as it is for equities because bonds are generally less volatile. If one can do better one should take whatever the market will give, but I will not chase this contract by buying at a higher premium. The same will apply to each of the remaining candidates on the list.

My next candidate is Capital One Financial (NYSE:COF). When the next recession hits COF should need to increase write-offs significantly on its credit card portfolio. What's in your wallet?

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$75.56

$25

$60

$1.80

$1.96

$1.88

1

1767

0.19

Jan/17

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I need one contract to protect 1/8 of a $100,000 equity portfolio against a loss of 30 percent or more. The total return from this hedge is potentially an estimated $3,312 with a cost of $188 (plus commissions).

Masco Corporation (NYSE:MAS) is tied primarily to the new construction. In a recession new housing and commercial building nearly grinds to a halt and MAS stock is predisposed to tumble when it happens.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$32.47

$10

$25

$0.60

$1.00

$0.75

3

1900

0.23

Jan/17

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I would need three contracts of MAS as described in the table to protect 1/8 of an equity portfolio from a loss of 30 percent or more. The potential estimated gain is $4,275 and the cost is $225, or $75 x 3, (plus commissions).

Six Flags (NYSE:SIX) has held up much better than I expected thus far but when the next recession hits far fewer people go to amusement parks and this stock is prone to disappointment during a downturn.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$57.70

$20

$50

$1.20

$1.50

$1.50

1

1900

0.15

Sep/16

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I would need only one September 2016 SIX put option contract to protect 1/8 of a $100,000 equity portfolio against a loss of 30 percent or more. The potential estimated gain is $2,850 and the cost is $150 (plus commissions).

Zions Bancorporation (NASDAQ:ZION) is a play that I expect to pay off once we see rising bankruptcies among the shale oil producers. ZION has significant loan exposure to energy and related supporting industries and I do not believe that the reserves for losses are anywhere near adequate to cover the coming losses in its loan portfolio.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$27.28

$5

$20

$0.54

$0.63

$0.63

3

2281

0.19

Jan/17

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I need three January 2017 ZION put option contracts as described above to protect 1/8 of a $100,000 equity portfolio against a loss of 30 percent or more. The potential estimated gain is $4,311 and the associated cost is $189, or $63 x 3, (plus commissions).

Goodyear Tire and Rubber (NYSE:GT) is more heavily tied to car manufacturing than to the aftermarket compared to competitors. It also has higher costs than the average for the industry. Earnings expectations for fiscal year 2016 are wildly optimistic. When the next recession hits, car sales will plummet and GT stock will fall along with them. Thus far the auto industry has been pulling sales from the future into the present and relying on financing of too many subprime consumers. I do not believe that can be sustained much longer.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$32.28

$8

$23

$0.50

$0.60

$0.60

3

2400

0.18

Jan/17

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I need three January 2017 GT put option contracts as described above to protect 1/8 of a $100,000 equity portfolio against a 30 percent loss or more. The potential estimated gain is $4,320 at a cost of $180 (plus commissions).

Level 3 Communications (NASDAQ:LVLT) has a history of seeing its stock price drop precipitously during each recession through which it has survived. I do not expect the next recession to prove much different.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$53.73

$20

$40

$1.05

$1.40

$1.25

2

1500

0.25

Jan/17

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I need two January 2017 LVLT put option contracts as described above to protect 1/8 of a $100,000 equity portfolio against a 30 percent loss or more. The potential estimated gain is $3,750 at a cost of $250 (plus commissions).

My final candidate is Boyd Gaming (NYSE:BYD). The gaming industry stocks usually lead the market lower. For this reason I am comfortable using September 2016 contracts with BYD. At the beginning of the next recession I expect BYD to drop like a rock.

Current Sh. Price

Target Sh. Price

Strike Price

Curr. Bid Premium

Curr. Ask Premium

Target Prem.

# of Cont.

Est. % Gain

% Cost

Exp. Mo./Yr.

$20.03

$5

$17

$0.75

$0.90

$0.80

3

1400

0.24

Sep/16

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I need three September 2016 BYD put option contracts as described above to protect 1/8 of a $100,000 equity portfolio against a 30 percent loss or more. The potential estimated gain is $3,360 at a cost of $240 (plus commissions). Once again, I want to stress that if I can buy any of the above put options below my target prices I will be happy to lower my cost and improve my return potential.

At this stage we need to have more patience that ever before. I may try opening some buy orders with limit prices and make them open until canceled so that I do not miss what I want should the prices get to my targets while I am out running errands. If the market goes higher, which it could, I will lock in lower costs as the premium on the above contracts fall. But I will not chase the premiums higher. That is the benefit of already being fully (or nearly so) hedged already. I will use this rally to extend my coverage into 2017 and have the flexibility to take profits on contracts that expire sooner when gains are available. I do not consider this a trading strategy. I remain fully hedged as much as possible. But the market will not go straight up or straight down so I will try to reduce my cost by taking gains on those positions that represent any hedge over what I need to remain fully protected. This is merely a matter of managing the cost of the hedge and it is much easier to do at this point because I am working with gains from previous positions. If I were starting out now my primary objective would be to become hedged, either fully or partially, to give me the comfort I need to continue to hold my dividend-paying quality shares.

Discussion of Risk

I want to discuss risk for a moment now. Obviously, if the market were to rally 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. 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. 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 (which is where we are today in my opinion), 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 hold put options on all of the stocks listed in this article.