Positioning for a Bumpy Ride

Includes: DIA, QQQ, SPY
by: Tom Armistead

As the VIX has returned to normal levels and the market slides along the top of recent 52 week highs, I have spent considerable time and effort reviewing and repositioning my portfolio to respond effectively to the action I expect going forward – about 7 to 8% annualized, with swings peak to trough of 6 to 8% every quarter.

As an aggressive value investor, with over 50% of my portfolio in options, primarily for leverage, the past year has been a good one. Risk/reward still justifies staying in the market, but leverage needs to be curtailed, and positions need to be adjusted to avoid giving back too much of the gains and function effectively when volatility swings back up.

What does that mean? The above strategy, couched in abstract generalities, sounds good but implementation involved taking specific concrete actions:

  • Raise cash up to 20% of portfolio. If the market hits an air pocket, buying opportunities or volatility selling opportunities will arise, requiring the availability of cash.

  • Sell covered calls where premiums are still attractive.

  • Buy back puts or calls where most of the premiums have been earned. As a rule of thumb, I consider buying back anything where 80% of the premiums have been earned.

  • Take profits on high beta cases. These will give back their gains very easily if a flight to safety develops.

  • Pare any oversize positions. I have a tendency to enlarge positions if they move against me. This time around, I cut two cases that were over 10% of portfolio down under that limit.

  • Cull according to someone else's opinion. Schwab has an A-F rating system, which has a momentum bias that my methods lack. I look twice at anything that they give a D or an F, it could be dead money or bad judgment. Morningstar and S&P have 5 star rating systems – anything with less than 3 stars I need to be able to explain why I differ.

  • Roll long term in the money options up, if credit of more than 9 for a spread of 10, or 4 for a spread of 5, is available. This reduces and defines downside risk, and the resulting positions will hold up better under high volatility.

  • Take out some downside insurance: I use puts on SPY. I have been using long term deep in the money puts. These are expensive compared to out of the money, but will reliably have certain values at defined downside points on the S&P 500. They're easy to project, and are better than cash in a down market. I plan to add to the hedge if the market continues upward.

  • Review any options positions that expire in the next 3 months. Are they going to produce cash, or require the use of it? How will they behave in the face of a rapid market movement in either direction?

  • Have a watch-list – I have starter or marker positions in a number of low volume/illiquid small caps, it may be easier to accumulate shares if there is a strong downdraft, plus an alumni account of cases I have sold off in the past year.

  • Leverage – reduced from 1.5 X to 1.2 X, using position delta and share prices to compute the dollar value of a portfolio consisting of shares only which would perform similar to the mixed options and shares actually employed. Plan to make further reductions as convenient.

  • Sell regularly – plan to sell about 1% of portfolio every time the S&P goes up 1%.

  • Update opinions – as earnings come in I update my notes and worksheets. Mr. Market sometimes gets it wrong, and if buying opportunities come up it is very helpful to have a definite and up to date opinion on valuation.

  • Listen to others. Seeking Alpha has articles and comments on stocks I follow and issues I need to be aware of. I follow those I consider to be well-informed and thoughtful. As a contributor, I can expose my opinions to critical evaluation and gain additional insight from comments and discussion.

Detail - The above involved quite a bit of detail work, trading far more frequently than usual. Under normal circumstances I make about one trade a day, slowly legging into the planned positions, taking advantage of small price changes. While adjusting I made 5 or 6 trades a day, taking whatever the market price was for what I wanted to do. Before I retired I worked in jobs requiring capacity for detail, and I believe that conscientious attention paid to options tactics accumulates an advantage over time.

For that matter, adequate attention to detail is a strength when analyzing stocks. A definite process can be followed. I use a 5 page worksheet which I complete by copy typing form S&P, Reuters or other financial reports, and it performs a fair number of mechanical analyses, including a default valuation. I visit the website, review any presentations found there, check out earnings conference call transcripts, and browse the financials and several professional analyst reports if available.

From there I try to come up with something that can be covered in one or two paragraphs, or a back of the envelope type valuation. But the point is, to make a systematic effort to review an adequate amount of information, then simplify to a few key points.

Short-term agnostic - Looking forward past the long weekend, investors who have had three days to think about 1st quarter performance, Friday's unemployment, and forthcoming earnings will have a definite agenda by the time they hit the office on Monday. I don't have a short-term opinion right now, just a queasy feeling that things have been going too good. If the adjustments made are well thought out, I will be in a position to respond to developments, including the unexpected.

Disclosure: Long Equities, short SPY as hedge