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Tom Armistead
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I'm a well-informed retail investor and post on SA in order to expose my thought process to critical examination and comment from readers. It makes me a better investor. I'm particularly proud of bullish macro articles posted in 2009 and later, in which I presented ideas that encouraged me to... More
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  • Starting To Build A Hedge 22 comments
    Jan 5, 2013 8:49 AM | about stocks: SPY, MET, PRU

    The S&P 500 (NYSEARCA:SPY) hit a 5 year closing high on Friday. Meanwhile, VIX plummeted to 13.83, which places it in its lowest quartile. Now would be a good time to start hedging again.

    I would consider the index to be at a mid-point valuation in the 1,525 to 1,540 area. At that point, there is no compelling reason to be invested in equities, although the lack of viable alternatives in the current low-interest environment does serve as an inducement, of sorts.

    With that in mind, and SPY at 146, I placed the following trade:

    Buy to Open 1 SPY Dec 20 2014 165.0 Put @ 29.50

    The plan is, to add another put every time SPY goes up another dollar. I've had good results with this method of hedging, since I'm always buying protection at the top. The last time I did it, I more or less accidentally closed the hedge at the bottom, scoring a very nice return.

    Why Hedge?

    Here's a chart:

    (click to enlarge)

    The market goes up more often than it goes down, by a substantial margin. But, when it does go down, losses can pile up quickly. At a five year high, the market is unlikely to never look back. Congress has many opportunities ahead of it, to subject the economic recovery to the Perils of Pauline. The world is a dangerous place.

    The distant expiration, deep in the money puts perform very predictably in downturns, and can be cashed in at a profit as a source of dry powder, or to cover immediate cash needs without selling assets at a loss.

    What If?

    What if the market continues to advance, inexorably destroying the value of the steadily increasing hedge? Long positions will increase in value. Also, as the strike on the put gets closer to the money, it will pick up time value. If, for example, SPY makes it up to 165 as of the end of 2013, and volatility stands at 11, the put will still be worth $6.

    But suppose VIX makes it up to 25, not unheard of. The put will be worth $15, as an approximation, using an options calculator.

    What else?

    I made a start on transitioning my portfolio toward Dividend Growth and away from Deep Value. I have outsize positions in MetLife (NYSE:MET) and Prudential Financial (NYSE:PRU), that together represent an extreme overweight in Financials and particularly Life Insurers.

    I started scaling out, at $1 intervals for PRU and 70 cent intervals for MET. I will be out of both investments if and when they hit my target prices. For now, these sales serve as a source of funds for the hedging operation. In due course, they can be redeployed into the more conservative Dividend Growth selections, hopefully in the wake of a correction.

    Disclosure: I am long MET, PRU, SPY.

    Additional disclosure: I own the Vanguard S&P 500 index mutual fund, so I'm net long the index. The hedge is simply a source of funds in the event of a correction.

    Stocks: SPY, MET, PRU
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Comments (22)
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  • SeekingTruth
    , contributor
    Comments (1335) | Send Message
    A good approach worth considering with some adjustments for the particular individual investor and his own outlook, needs and techniques, of course. Many Thanks!
    And as is said, by some: "I would rather be lucky than smart" , which seldom works in investing, but it worked for you on Nov. 15, when you proved it is better to be Both Lucky AND Smart!
    5 Jan 2013, 12:36 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » ST,


    Thanks for you kind words. Sometimes I think that in order to get lucky, you have to do something and hope it works, or maybe stand in the right place and wait for something to happen.
    5 Jan 2013, 03:16 PM Reply Like
  • dancing diva
    , contributor
    Comments (2603) | Send Message
    Tom - that Dec 2014 165 put is far too rich for my blood; it has an implied volatility near 23%. And if the market is at 165 in late Dec 2014 I'd wind up losing more money on the put than I'd make on my positions, assuming they gained roughly what the S&P did.


    I don't know when you last employed this approximate 2 year strategy. But remember in the mid 2000's the market was far more complacent - and the spread between the volatility in the deferred vs. nearby options was much lower than today.


    I think a better protective play is to buy the April 144 puts for roughly $4.00. It protects you if we go below the December lows, the volatility is only 16.5%, gets you through the debt ceiling debates, one round of earnings and the early phase of the second round. Additionally, we'll get to see at least the initial impact of the higher tax rates on the economy. The volatility is even lower in the at the money puts; the April 146 closed Friday with a bid/ask of 4.73/4.79. For roughly $2 more you can go out to the June 2013 options; the vol is roughly 1% higher.


    If the economy/earnings still looks OK at that point you can wait to buy the far deferred options at a far lower volatility.
    5 Jan 2013, 04:20 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » dd,


    I just checked Schwab, they show implied volatility at 15.%, not sure we're looking at comparable information.


    The problem I have with using shorter terms and closer to the money to hedge is, time hurries on, and a lot of the gains from the hedge are time value and sort of ephemeral. That invites or demands timing the market, you get this decision whether to take the profits or watch them waste away.


    The approach in the article worked very well in 2010. For 2011, I bought the hedge right, but closed it well before the bottom. I didn't believe Congress was going to do what they did, which tanked the market needlessly. In 2012 it worked very well, bought right and closed timely.


    I agree the April puts look attractive, as you say they cover a lot of ground, it would be surprising if something doesn't happen between now and expiration.
    5 Jan 2013, 04:33 PM Reply Like
  • dancing diva
    , contributor
    Comments (2603) | Send Message
    Tom - I was using the greeks at The implied volatility for the Dec 2013 at the money spy puts is 20%, Dec 2014 at 23%. With the one month vix just under 14%, and at the lowest level in awhile, does it make any sense at all that the implied volatility for two years out is 15% given all the uncertainties? What options market maker in his right mind would sell you 15% implied volatility 2 years out?
    5 Jan 2013, 06:11 PM Reply Like
  • dancing diva
    , contributor
    Comments (2603) | Send Message
    Does anyone else use another provider? Can you confirm/deny the implied volatility of the Dec 2014 165 put is 22.8?
    5 Jan 2013, 06:43 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » I have Ameritrade, they have a Greeks/Analytical view that shows 16.099, 30 day historical volatility is 25.80...
    5 Jan 2013, 07:03 PM Reply Like
  • Valueplay98
    , contributor
    Comments (584) | Send Message
    I'm sure there is someone who can explain it better, but different softwares count IV slightly different.


    The important thing is to remember the ^VIX (Symbol in Yahoo Finance) is based off the option price of the SPY.


    So I don't think you'll see IV go down on those long dated puts with a VIX under 14. (At least not anytime soon.)


    FWIW at eOptions their platform says the Dec 2014 165 Puts IV is 34.24 so you got 4 different platforms with 4 different IV 's
    6 Jan 2013, 04:03 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » The price on these options is extremely sensitive to implied volatility. I experimented with it using the CBOE options calculator.


    An implied volatility of 17.75 matches the current mid bid/ask quote at CBOE, with the market closed.


    If implied volatility was 25, the puts would be worth $34.50, $5 more than I paid for them.


    I don't have enough experience with options on SPY to predict what the relationships are between the deep in the money distant expirations I normally use and the shorter term near the money that are traded in much heavier volumes.
    6 Jan 2013, 06:55 AM Reply Like
  • Valueplay98
    , contributor
    Comments (584) | Send Message
    I just thought I'd point on in TOS/AMTD that you can choose which volatility you'd like:


    Setup> General Tab > look down for "Volatility Strategy"


    There are 3 choices - the default is "Individual IV" and there there is "V smile approximation" and "Fixed Vol Per Expiration".


    (I was looking for something else and found the setting.)
    6 Jan 2013, 07:31 AM Reply Like
  • Robin Heiderscheit
    , contributor
    Comments (2198) | Send Message
    TA, this is a great time to be buying options, I think. Personally I am hedging with options on VIX futures. The volatility on these options dropped 35% this week, biggest drop ever. So you have low market volatility and low volatility volatility. I have never seen VIX futures options cheaper.




    And just when you finally had me convinced that it was safe to buy MET!
    6 Jan 2013, 08:57 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » Robin,


    During the financial crisis, there were some investors who had trouble with VIX hedges, the problem was, that the more distant expirations didn't go up enough to make them work that well. Short term I think they work well, VIX could head back up on this or that piece of bad news very easily.


    Don't count MET out. I have twice as much of it as I should, it was a trade that went against me and I elected to hold. The stock should do very well if interest rates continue to rise, and if volatility stays low.


    So for the first half of my MET position that I sell off, I'll be adjusting an extreme overweight back to something more normal.
    6 Jan 2013, 09:30 AM Reply Like
  • sthiruva
    , contributor
    Comments (2) | Send Message
    When you say VIX futures, do you mean VXX?
    11 Jan 2013, 01:39 AM Reply Like
  • jimmy46
    , contributor
    Comments (1804) | Send Message
    I would consider the index to be at a mid-point valuation in the 1,525 to 1,540 area. At that point, there is no compelling reason to be invested in equities,"""""""


    I think 2013 might be an interesting year,
    house prices are up 23% in the last year,
    can't remember if that's for Nevada or the whole US,
    but clearly the tide has turned, and strongly for house values.
    Still a lot of houses to go thru the foreclosure process,
    but they are being trickled out rather than dumped.


    This should spur new construction which has been moribund for 5 years, which use to be 10% of GNP, but the last 5 years,
    a fraction of that, and a lot of other good effects.


    It might also cause the FED to ease off on monetary policy,
    and who know what effect that'll have.
    People may migrate from DG stocks back to CD's when interest rates go up.


    Good news will come out on different days than bad news,
    so there might be periods of volatility,
    but this might be a very good year.


    I've been about 40% cash the last 2 months,
    so I can take it either way.
    6 Jan 2013, 03:15 PM Reply Like
  • jimmy46
    , contributor
    Comments (1804) | Send Message
    I forgot to mention, was at my bank's internet site looking at mortgage rates, they're offering home equity loans for the first time in 4 years or so.


    They must believe home prices have turned the corner to go back into that area of lending that had a lot of losses in the past.
    6 Jan 2013, 03:35 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » jimmy, do I hear a certain amount of nostalgia for the good old days? House prices on a tear, the house as ATM, banks shoveling out money to all and sundry?


    The pattern has been for the index to more or less reach its midpoint and then fall back for another try. Very possibly it will get past the midpoint and motor higher.


    At that point I would lighten up on my equity exposure, the challenge is to find something else to invest in. Of course if we do go back to the good old days, the question would be, how long is it going to last this time? Or, is this time going to be different?
    6 Jan 2013, 03:56 PM Reply Like
  • The Last Boomer
    , contributor
    Comments (992) | Send Message
    Tom, I understand that from a purely technical perspective it may be worth building a hedge at this point: 5-year high, the market is likely to retreat somewhat, stocks are fairly valued, etc. But when you look at the economy, it is hard to come up with a bearish case. Consumer is recovering, gross private domestic investment is growing healthily, the corporate profits may stagnate at this very high level but nobody is predicting that they'll drop like a stone. From a long-term perspective, this still looks like good time to buy stocks selectively, especially in still undervalued sectors like energy or telecommunications.
    7 Jan 2013, 10:59 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » LB,


    I agree with you on the economy, and I still see a lot of stocks that I think are undervalued - I own a lot of them.


    Over the past several years I've come to view hedging as a source of funds for when the market declines, either as dry powder or to support my normal living expenses.


    I have an alert set on one of my accounts, when VIX hits its 1st quartile, about 14.62, I start hedging, progressive. Soon enough, something happens.
    7 Jan 2013, 01:35 PM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » Thanks everyone for your kind words and appreciation on this article.


    The editors typically are looking for material that has immediately actionable ideas. I wasn't sure this would meet their criteria, so I put it in as an instablog, even though that gives it a lot less visibility.


    It's been a pleasant surprise to see the positive response here, so I may do some more in this vein, if and when the ideas come naturally.
    14 Jan 2013, 03:10 PM Reply Like
  • Robin Heiderscheit
    , contributor
    Comments (2198) | Send Message
    Tom do you still have FV for the market around 1550 and if so are you hedging more tightly up here in the 1740 area?


    I personally think a blow off top (nazz 5000 maybe early next year?) is as likely as a pullback. I do believe that small caps are the most overvalued of my lifetime, even more so than 1999-2000 when the overvaluation was concentrated in large caps.
    18 Oct 2013, 10:33 AM Reply Like
  • Tom Armistead
    , contributor
    Comments (5742) | Send Message
    Author’s reply » Robin, I don't have any hedge at all. I closed it on 2/14 as I wasn't clear in my thinking about market level and future trajectory of the market. After taking a long walk in the woods, I'm back in the market, long only, via the Synthetic DGI portfolio.


    I'm holding a lot of cash. The market could very well continue higher for an indefinite period of time, due to low interest rates being perceived as permanent. My overall position is long but defensive. I'm willing to underperform so as to avoid getting caught in a severe correction.


    I see the market as fairly valued at 1,625 on the S&P 500.


    I think margins will contract, by no means as severely as what Hussman and the like are looking for.


    I would need the S&P 500 at 1,500 before I would abandon the defensive approach.
    18 Oct 2013, 10:51 AM Reply Like
  • Robin Heiderscheit
    , contributor
    Comments (2198) | Send Message
    Thanks for the update.
    18 Oct 2013, 11:18 AM Reply Like
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