How Do I Manage My Personal Portfolio?

Includes: MOS, POT, ZSL
by: George Acs

When I say "My Personal Portfolio," I really only use that expression to illustrate a general question: what are the considerations when following a covered option strategy? There are many -- sometimes seeming to move in different directions -- but they should paint a coherent picture of the objectives of the individual investor and goals for his portfolio.

In my own case, I use the covered option strategy exclusively, but it was an evolutionary process. That process started when I rolled over a workplace 401(k) and decided that, rather than roll it into an existing managed account with a broker that I had trusted for about 20 years, I would finally try to put into practice the strategy that I'd been testing for years prior. Although I had been very loyal to my broker and followed him from brokerage house to brokerage house, I began to look at managing a portion of my own assets as an expression of the need to be diversified.

That was in 2002, and the rollover represented approximately 35% of my total assets at the time. He knew about the account and encouraged me to "try." I think he fully believed that I would eventually consolidate my accounts after the "fling."

Then, very unexpectedly, my broker passed away. Rather than start anew, I decided that my returns on that small piece I had been managing were good enough to warrant going in with full commitment. That was about five years ago. From the beginning, there have been ups and downs in the markets, each of which provided a living laboratory of results.

Although I now virtually exclusively use a covered option strategy, there are certainly a number of modifications that can be applied to an individual's portfolio based upon investor temperament and prevailing market conditions.

The one constant is the need to diversify by sector, however. For example, just a few short months ago I held shares in Goldman Sachs, JPMorgan, Morgan Stanley and Wells Fargo. That's a lot of Financial sector holdings, but not necessarily if the portfolio contained 25-30 stocks in total.

I generally think in terms of about 10 sectors. Therefore, no single sector should comprise more than about 10% of asset holdings. Very often sectors rotate in and out of favor. So I do recognize that if shares in a particular sector are assigned, it is very possible that subsequent purchases of new stocks using funds from assignment may go toward purchase of shares in an under-performing sector, rather than back into the out-performing sector from which shares were assigned. However, an individual may already own shares in the under-performing sector in question, and any new shares may push the total beyond the "limit."

I believe that is an acceptable action under the circumstances, and it is very akin to dollar cost averaging and rebalancing. The trend of the stock market with regard to sectors is that they do rotate. An over-representation in a single sector, particularly due to cost averaging down during an out-of-favor period is very often followed by a bounce-back in prices as favor returns and the cycle begins anew, as those shares are subsequently assigned.

At the moment, the portfolio, for example, holds shares of Potash (NYSE:POT), a fertilizer company. In the two weeks of holding, shares are down almost 5%, while option premiums represent a bit more than 2% of purchase price. The entire sector is very recently depressed, possibly offering an opportunity to pick up additional shares of Potash, or perhaps its sector cousin, Mosaic (NYSE:MOS). For the individual investor, if such an alert is sent, it should be considered not only in the context of its own merits at a moment in time, but in the context of whether the addition of shares in that sector would place undue portfolio risk due to over-representation.

Even if the thesis is sound, and even if the outcome turns out to be a positive one, the more often you "break the rules," the easier it becomes to consistently break the rules.

Additionally, based on the number of stocks in your portfolio, no single stock should be held in disproportionate numbers. In the past and even at the moment, I've erred in that regard -- sometimes to my benefit, but most often to my detriment. In my case, I tend not to get overly concerned when looking at paper losses, but I feel incredible relief when those losses are reversed for those positions that occupied much too large of a position in my portfolio. I typically vow to never let that happen again, but then fall victim to "portfolio creep" and quietly accumulate shares as prices drop. And then that cycle begins anew, and is also capped with a vow to never let that happen again.

At the moment, I do hold about 25 stocks, and so each holding should represent no more than 4% of the total asset value. Ten stocks? 10 percent.

Knowing that lots of people, including myself, like to occasionally speculate, there can be some room to accommodate that part of human nature. Obviously, the younger you are and the more opportunity you have to recover from an untoward move, the more you can speculate with your portfolio.

As a general rule, whatever the proportion of a given stock should hold in my portfolio, the sum total of all speculative issues shouldn't exceed half of that amount. So for example, If you hold 10 shares in your portfolio, the speculative portion of all speculative holdings shouldn't go much beyond 5%. Five speculative stocks and 10 traditional? The sum total of all 5 speculative stocks should still not exceed 5% of the total portfolio.

Of course, there may be some leeway in terms of how you define "speculative." Some people look at the "beta" measure of a stock, or the measure of variability of its price relative to the overall market. That measure is not forward-looking and can be very deceiving. For example, ProShares UltraShort Silver (NYSEARCA:ZSL) has a very low beta, but it is surely a speculative issue in that timing of purchase or sale can be critical. The difference with that kind of speculative issue is that sooner or later, the pendulum swings. You just need the patience and the antacids.

Buying shares of a blue chip company can be just as speculative as purchasing shares of a high flyer, if the purchase comes right before earnings are announced. So speculation can take many forms.

Other speculative issues are the kind where shares may make big moves following some specific event that may or may not occur, such as drug approval for a small cap biopharmaceutical company. Those kind of plays, if the event doesn't occur, almost never exhibit recovery when the stock price dives. The rich option premium is very often not worth the risk, particularly since the rug may be pulled out at any moment from under the shares.

Of speculative issues, I stay away from the latter. The ones that have all hopes and dreams pegged to an event, especially one that is out of a company's control, is frightening to me.

Now, when it does come to managing holdings in a covered option portfolio, the next question becomes, what proportion of your shares do you want to hedge?

The answer to that question shouldn't be fixed. During down markets or times when prices are meandering, it may make sense to cover the majority, if not all of your shares, to provide protection. If those shares are assigned, in down and meandering markets, there is typically an opportunity to pick up different shares at reasonable prices. If not, just wait a short time and the shares that were just assigned are very likely to return to their previous strike price. The longer you sell covered options, the more you realize that there is very little reason to reinvent the wheel or spend time trying to discover new and below-the-radar companies.

When prices are exhibiting an uptrend, it may make sense to hedge only a portion of your positions in order to benefit from an individual stock being part of the market trend and achieving capital gains on shares in addition to gains from option premiums and dividends.

Of course, during market trends, you also need flexibility in your decisions regarding strike prices. When the market is trending higher, consideration can be given toward using higher strike prices, or even using multiple strike prices. With the very recent addition of many half-dollar-denominated strike levels, there are lots of opportunities to customize an individual portfolio's protection based on tolerance for risk and desire for income or price protection.

Of course, if a market is trending downward, the use of in the money (ITM) calls may be very useful as any drop in stock price, especially for short-term options, will be matched at nearly a 1 to 1 ratio in the option premium.

Finally, an individual investor can decide what time frame to use when selling covered options.

The investor that is highly confident in the performance of his shares or their ability to retain value in a relatively narrow range may select longer-term options. That's especially true if the primary objective is to complement return, and when buy and hold has been your predominant approach to investing.

I started the covered option strategy with longer-term option sales, but came to the conclusion that they were not responsive enough for my temperament to the rapidly changing market landscape to be effectively taken advantage of in the event of price swings. Although I much prefer the newer weekly options when available, there are certainly times, especially when volatility is present, that it makes sense to lock into a longer option timeframe in order to secure the higher premium. Although such higher premiums may appear lower on an ROI basis, it is deceiving to extrapolate a weekly option ROI, as you can't always guarantee being able to sell a weekly option and receive a reasonable premium for the risk taken of losing shares to assignment.

Ultimately, as an investor, a decision must be made. Do I want to create revenue streams for personal use, do I want price protection, or do I want to generate additional capital for re-investment? These are certainly not mutually exclusive, but your own needs color how you perceive investing results. I evolved from using income to purchase additional shares to growing assets to the point that income from sales now has replaced employment. Of course, like everything else mentioned above, I may choose to change my objective if the market changes its tone.

Above all, evidence clearly indicates that the most important thing an investor can do is to select positions or take actions that help to outperform in a down market. It is far more difficult to recover from a 20% loss than a 19% loss. You don't have to go to the extremes of being a survivalist in your investing strategies and being left far behind when there are no calamities. Instead, simply know yourself and know your holdings.

Disclosure: I am long POT, and I may purchase shares of MOS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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