The Time To Hedge Is Now! December Update - Part I

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Includes: JBL, MU, TEX
by: Mark Bern, CFA

Summary

The article introduction contains a brief overview of the series, a link to more detailed explanations and some reason to hedge now against the next bear market.

How the hedge performed during the October slump in equities.

What can we learn from this experience?

Discussion of the risks of employing this strategy versus not being hedged.

Back to the July Update

If you are new to this series you will likely find it useful to refer back to the original articles, all of which listed with links in this Instablog. In the 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 explanation of the candidate selection process and 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 want to make it very clear that I am not predicting a market crash. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets.

We are already past the average duration of all bull markets since 1920. The current bull is now longer in duration than all but three bull markets during that time period (out of a total of 15). The three that remain longer are 1949-1956 (70 months), 1921-1929 (97 months), and 1990-2000 (117 months). By February of next year this bull market will move into third place, passing the bull market with the least onerous consequence. So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, and I will be the first to admit that I am probably earlier than I suggested at the beginning of this series. I feel confident that the probability of experiencing another major bear market will rise in the coming year(s). It may be 2015, 2016 or even 2017, before we take another hit like we did in 2000-2002 or 2008-09. But I am not willing to risk losing 50 percent (or more) of my portfolio to save the less than two percent per year cost of a rolling insurance hedge. I am convinced that the longer the duration of the bull market lasts the worse the resulting bear market will be.

I do not enjoy writing about the potentiality of down markets, but the fact is: they happen. I don't mind being down by as much as 15 percent from time to time; that is just a hiccup in the buy-and-hold investing strategy. But I do try to avoid the majority of the pain from larger market drops. To understand more about the strategy, please refer back to the first and second articles of this series. Without that foundation, the rest of the articles in this series may not make sense and could sound more like speculating with options rather than an inexpensive way to protect your portfolio against catastrophic loss.

As I mentioned in the first article of this series, equities could continue higher for longer than we may expect. As we begin to roll our positions, I continue to recommend buying partial positions as the market moves up. Here is a quote from the first article.

"I don't advise investors to initiate their entire protection position all at once. There are always rallies to take advantage of along the way and, assuming that we still have higher highs coming in the future, it would be more prudent to take only a portion of the position today and wait for a better opportunity to buy contracts at lower prices in the future."

The reasons why the current bull market could continue higher have a lot to do with Fed policy, in my humble opinion. As long as the Fed continues to hold (short term) interest rates near zero and maintains its enormous balance sheet of assets at nearly $4.5 trillion, financial institutions, corporations, and wealthy individuals will continue to borrow for next to nothing and invest for return. Because of the nature of the Fed policies, which may be adjusted as necessary depending upon the sustainability of economic growth as determined by the FMOC, liquid investments are in vogue. Thus, equities offer the flexibility, yield and potential appreciation that attract these large investors. We are still in a risk-on environment. When that will change, I do not pretend to know. But it will.

I included corporations because many large companies are borrowing at historically low rates and using the money to buy back shares to prop up earnings per share even when revenue growth is tepid. If companies believed that the economy was ready to expand at a faster pace it would stand to reason that more of that new capital would be reinvested in capacity or product development. But money is cheap to borrow right now so it makes it hard to argue against the strategy to boost EPS.

In this article I will provide a table with all the positions I currently hold in my hedge strategy, an assessment of how the hedge strategy worked during the October correction, and what we can learn from the performance of the hedge thus far. In the next part to this update I will include an explanation of how I intend to roll my positions to extend my portfolio insurance coverage, adjustments I plan to make in the candidates to use going forward, and a table containing my favorite put option contracts at this time.

At one point in mid-October, the S&P 500 index was down about nine percent. The unrealized, aggregate gain on my hedge positions was at 40 percent at that point. I had a lot of contracts that were still underwater (25 to be exact) but the ones that were in positive territory (18 out of a total of 43) had gained enough to more than offset those losses. Unless we experience another correction by the end of the year most, if not all, of my positions should expire worthless. I don't consider this a blunder. The hedge provided me with the insurance against major loss that was intended. I gave up a little of my income but was able to stay in the game without being concerned about suffering a major setback in my retirement years. I include break even positions as losses.

Here are the positions I still hold and the gain/loss that had occurred in October (all positions listed are put options bought with January 2015 expiration).

Stock Symbol

Strike Price

Premium Paid

Premium Available

Gain / Loss

% Gain / Loss

BID

28

.85

.45

- .40

- 47%

BID

28

.63

.45

- .18

- 29%

ETFC

12

.26

.13

- .13

- 50%

ETFC

15

.35

.30

- .05

- 14%

GT

15

.20

.20

- .00

- 00%

GT

17

.10

.55

+ .45

+450%

GT

20

.28

1.83

+1.55

+554%

JBL

13

.30

.05

- .25

- 83%

JBL

13

.20

.05

- .15

- 75%

KMX

25

.13

.05

- .08

- 62%

KMX

30

.13

.20

+ .07

+ 54%

KMX

35

.25

.50

+ .25

+100%

LB

34

.18

.05

- .13

- 72%

LB

41

.30

.10

- .20

- 67%

LVLT

27

.33

.25

- .08

- 24%

LVLT

30

.35

.30

- .05

- 14%

LVLT

32

.45

.60

+ .15

+ 33%

MAR

45

.48

.25

- .23

- 48%

MAR

45

.20

.25

+ .05

+ 25%

MS

20

.16

.06

- .10

- 63%

MS

22

.09

.11

+ .02

+ 22%

MS

25

.19

.28

+ .09

+ 47%

MU

15

.21

.12

- .09

- 43%

MU

20

.20

.60

+ .40

+200%

RCL

32

.29

.19

- .10

- 34%

RCL

37

.28

.44

+ .16

+ 57%

RCL

40

.41

.66

+ .25

+ 61%

STX

30

.28

.12

- .16

- 57%

STX

40

.16

.51

+ .35

+219%

TEX

23

.33

.85

+ .52

+168%

TEX

26

.25

1.95

+1.70

+680%

TEX

27

.33

2.40

+2.07

+627%

TPX

32

.55

.20

-.35

-64%

TPX

32

.20

.20

-.00

-00%

UAL

25

.47

.50

+.03

+ 6%

UAL

27

.48

.70

+.22

+ 46%

USG

22

.73

.70

-.03

- 4%

USG

20

.35

.33

-.02

- 3%

VECO

23

.75

.20

-.50

-73%

VECO

25

.60

.60

-.00

-00%

WSM

35

.04

.05

+.01

+25%

WSM

38

.10

.05

-.00

-00%

WSM

47

.30

.20

-.10

-33%

All option contracts listed in the table above expire in January 2015. I have based all purchase prices upon the actual premium paid for each contract in my own accounts. The available premiums were estimated as the average between the bid premiums and ask premiums at the time. In purchasing options, I try to use common sense when entering a limit order by offering to buy at something above the current bid but below the ask premium. I usually try to split the difference and get most orders filled. The point of this first iteration of the hedge strategy is that it performed close to expected by already showing a reasonable profit while the overall market fell less than ten percent. The majority of the expected gains from our hedge are expected to materialize only when the market has fallen by more than 15 percent.

We need to remember, though, that as the option expiration date become much less than 60 days the ratio begins to change more rapidly. Thus, it will take a much larger drop in price of the underlying price to produce the same increase in premium. Also, if the stock price is close to the strike price the relationship between the option premium and the stock price is much stronger as in the case of Terex (NYSE:TEX). The current price of the stock is $28.13 (as of the close on Friday, December 05, 2014). I hold two long put option positions in TEX (multiple contracts in each) with strike prices of $26 and $27. Both positions remain profitable. The stock price is trading sideways within a range, the company has missed earnings expectations in the last three quarters, and revenue expectations for 2015 are flat compared to 2014. The future does not appear bright for TEX, but the price could remain range-bound until the next earnings report. That may not be in time to help my positions, so I intend to take profits as soon as I replace those positions with some new options expiring at a later time.

Now I want to explain a little bit about what I have learned. First, in some cases the stocks did not respond to a general pullback in equities as much this time as in the past. I plan to either remove those candidates from the risk or reduce my weightings in future hedge positions. We should focus more on the candidates that have performed the best most recently. Second, I need to move the strike prices up because the general market has risen and the stock prices of our candidates have risen also. Third, I need to adjust some of the target prices upward on some of our candidates since a 30 percent fall from currently levels is not likely to take all of our candidates stock prices down as low from current levels as it would have from the levels in place when this series began. Fourth, I will want to focus more weighting of my hedge position on those candidates for which the ratio between the stock price and the strike price produced gains at higher differences. I will explain this in greater detail in Part II as I reveal the remaining candidates, which ones I believe hold the greatest promise and why.

One good example is Micron Technologies (NASDAQ:MU) which, with three months remaining until expiration, had produced a gain of 200 percent when the price of the stock was still 26 percent above the strike price. Compare that to Jabil Circuit (NYSE:JBL) for which the options were still priced at a loss of 75 percent or more when the stock price was 30 percent over the strike price. My MU positions were more efficient at producing a profit that my JBL positions. I could make adjustments to future JBL strike levels but then the potential gains relative to the cost of those positions would not fit the profile used in this strategy.

This first iteration of the strategy has provided information and allows for refinement. First, some of the candidates did not respond well during the October general downturn in equities. By this I mean that the options did not lose as much relative to the price movement as was the case in earlier bear markets. The items I look at are: price movement of the individual stock(s), the movement of the option premium relative to the movement of the stock price, and the movement of the option premium relative to the difference between the stock price and the strike price.

In the case of the stock price movement, I want to know whether these stocks fell as fast as or faster than the overall market did. In terms of the option premium relative to the stock price, I look for option premiums movement accelerating as the stock price falls. The third item, option premium relative to the difference between the stock price and the strike price, can tell me two things. The first is whether I chose an efficient strike price level, or does it need to be moved higher. The second is whether options on the stock are an effective hedge. How I gauge this last parameter is by looking at the point at which the option begins to turn a profit. I want the option to break even while the price of the underlying stock is still at least 20 percent above the strike price of the option while there are about three months remaining before expiration. With longer to expiration we can expect to see a profit at a higher percentage above the strike price due to the time value included in the premium.

I shall explain more and provide some individual analysis on candidates in Part II. That article will also include an explanation of how to roll our positions to keep our portfolios protected as well as the new options contracts I prefer for each remaining candidate.

If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit less than two percent of my portfolio value to this hedge. If we need to roll positions before expiration there will be additional costs involved, so I try to hold down costs for each round that is necessary. I do not expect to need to roll positions more than once, if that, before we see the benefit of this strategy work.

I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2015 all of our option contracts could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. And if that happens, I will initiate another round of put options for expiration in January 2016, using from three to five percent of my portfolio to hedge for another year. The longer the bull maintains control of the market the more the insurance will cost me. 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 how much longer this bull market can be sustained and the potential 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 three percent) to insure against losing a much larger portion of my capital (30 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than five 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. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, I expect a much less powerful bear market if one begins in 2014; but if the bull can sustain itself well into 2015, I would expect the next bear market to be more like the last two. If I am right, protecting a portfolio becomes ever more important as the bull market continues.

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.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.