3 Strategies To Protect Gains Without Higher Taxes And Limiting Returns

Includes: CVX, SPY, XLE, XOM
by: Efficient Alpha

The market had its first losing week in eight last week but still fell by less than a third of a percent. The S&P500 is up 3.6% year-to-date and 15.4% over the last six months. While the market continues to make new multi-year highs and retail investors have found new faith in equities, some insiders are taking their profits. Investors may want to explore options strategies rather than selling out of their positions to avoid tax consequences and retain upside potential.

Markets at Multi-year Highs

Before last week, the market had continuously been reaching new multi-year highs. This month, the S&P500 closed at its highest level since November 2011 with volatility at levels rarely seen over the last few years.

That kind of market makes me nervous.

Among the biggest threats to the market is undoubtedly the $85 billion in automatic spending cuts in sequestration that will hit the economy on March 1st. The National Governors Association told Fox News this weekend that an analysis of impacts on the states shows that the automatic cuts could push the country back into recession. Even without the sequestration, revenue growth has slowed over the last few quarters and data has showed a struggling economy. Combine a sluggish U.S. economy with Europe projected to contract again this year, and optimism for market highs may be short-lived.

Evidently, some already see the best behind us. Over the past three months, insiders have made twelve stock sales for every one purchase, the highest ratio since 2011. Executives at almost a third (30.6%) of the S&P500 companies sold shares between February 11th and February 15th with sales outnumbering purchases by 17 to1, meaning the selling pressure may be accelerating. When the ratio has been this high in the past, it has been followed by a 5.9% drop in the overall market.

Not everything is pointing to lower prices. Inflows into equity mutual funds and exchange-traded funds for the month of January totaled $34.2 billion, the highest since January 1996, and may mean that retail investors have finally seen their faith restored in the markets. If this trend continues, it could support the markets against economic obstacles.

Despite the tug-of-war between inflows and economic obstacles, the market does seem to have gotten a little complacent over the past month. The chart below overlays the S&P500 with movements in the volatility index (VIX) since 2010. Circled are the six occurrences where annualized deviation in the VIX has fallen below 15% over a one-month period, signaling complacency in the market. Over the last three years, this has led to an average loss of 0.5% in the S&P500 over the proceeding six months with losses as great as 9.1% in 2011.

While the measure of complacency does not guarantee market losses ahead the market faces some significant obstacles and I am using options strategies to protect recent gains.

VIX and S&P500
(Click to enlarge)

Three Strategies to Limit Risk and Maintain Upside Potential

One of the most common forms of portfolio protection is buying put options in the SPDR S&P500 (NYSEARCA:SPY). The typical hedge is formed by dividing the portfolio value by the strike price on the options contract, rounded to the nearest hundred. For example, I would buy 7 contracts (700 puts) at a strike of $150 to protect a $100,000 portfolio. Using the March options, this would cost $952 at $1.36 for each option with a March 27th expiration. If the fund closes above $150 on expiration, the contracts expire worthless but I keep any gains on my portfolio. If the index falls by 5%, the $3,101 gain on the put options reduces the loss on the portfolio to just 1.9%.

Investors can adjust the expiration date and the number of options they purchase to change the level of protection. I prefer using longer-dated options rather than having to regularly open a new hedge but I pay a higher premium in return for the longer time to expiration.

Another strategy is to take offsetting positions in weaker competitors to the stocks you have in your portfolio. An investor with a long position in Chevron (NYSE:CVX) may take a hedge position in Exxon Mobil (NYSE:XOM). Chevron trades more cheaply than its larger rival at 8.7 times trailing earnings against 9.2 times for Exxon despite stronger profitability and a higher dividend yield. The chart below shows that the two stocks have moved in tandem over the last five years. In fact, the correlation of returns is extremely high at 0.90 over the period. Correlations range from negative 1.0 (inversely related) to positive 1.0 (perfectly related).

Exxon Mobil and Chevron Price Chart
(Click to enlarge)

Besides buying put options, investors can use an alternative strategy called a bear spread to protect against losses. This involves partially funding the purchase of put options by selling puts at a lower strike price. For example, buying the $90.00 March put options on Exxon while selling the $87.50 puts means a net cost of $0.92 for each option. The strategy is limited to a payout of $1.50 per option, limiting the amount of protection but also costing less than traditional portfolio insurance.

A third strategy may be to take a hedged position in specific sectors rather than the overall market. An investor with a large position in energy stocks may want to use the Energy Select Sector SPDR (NYSEARCA:XLE) to more closely hedge their portfolio. The fund holds shares of 43 energy companies with weights of 17.5% and 14.8% in Exxon Mobil and Chevron. The sector ETF has also been highly correlated to the two companies over the last five years at a correlation of 0.91 with Chevron and 0.88 with Exxon Mobil. As with the position in a correlated stock, the hedged position in the sector fund will not completely protect against losses in the long position and may backfire if the long-holding decreases while the hedging investment increases.

Limiting Taxes but not Upside Potential

Two obstacles typically keep investors from protecting their portfolio in the face of possible near-term losses. The first is that selling out of part or all of their positions means they risk losing out on further upside in the markets. The second obstacle is that selling out of positions held for less than a year will result in higher taxes.

Fortunately, the use of the option strategies above can limit or remove both of these obstacles. By taking a hedging position in the overall market or in investments correlated with holdings, the investor can protect their portfolio from market losses while still enjoying upside potential in their favored investments. By opening new positions, the investor can potentially avoid or limit the higher tax bill with a managed hedge. If stocks continue upward, the short-term loss in the hedge can be used to offset portfolio gains. If stocks do fall, then the gain on the hedge position should still limit losses even after the tax consequences.

Disclosure: I am short XLE, SPY. 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. Author has bear spread on XLE and SPY and a bull spread on XLE.