The Time To Hedge Is Now! August 2016 Update

|
Includes: ADSK, BID, ETFC, GT, JNK, KMX, LB, LVLT, MAR, MAS, SIX, TPX, ZION
by: Mark Bern, CFA

Summary

Why I hedge.

Candidates to consider while the market is in record territory and volatility is low.

A brief discussion of the risks inherent to this strategy.

I hope that my articles provide the above to some investors who feel they need it!

Back to Close June Positions

Strategy Overview

If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog. It may be more difficult to follow the logic without reading Parts I, II, IV and X. In 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 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 provides 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 sizeable market correction.

I have stressed in previous articles of this series that I generally do not predict recessions or bear markets. Recessions and market corrections are just part of the investing experience. They occur when we least expect them. This is why I hedge. I began in 2014 by using about 1 ½ percent of the value of my portfolio to hedge against a potential portfolio loss of 30 percent or more. Then, as I was able to capture some sizable gains from a few positions, my cost for that first year was reduced to less than one percent of my portfolio. It amounts to an inexpensive form of insurance and provides me with peace of mind. Last year my gains were much more significant, and I was able to offset all of my hedging cost for 2015, the remaining costs from 2014 and have plenty left over to extend my hedge well into 2016. So, now I am basically working with house money, so to speak, and my portfolio remains fully hedged against loss. For a full accounting of the results from last year and a summary of 2014 and 2015 please refer to this article.

If the market moves to new highs and I miss the next ten percent move higher I will not be distressed. As long as I miss the majority of the next big leg down, be it 30 percent or 50 percent or more, I rest well at night knowing that I kept my portfolio intact. I prefer to buy stocks at prices that I consider to be bargains relative to the value of the company. There is very little that meets my criteria in that regard in the markets today. Thus, I remain cautious and fully hedged.

New Positions to Consider

I am trying out a new format for the series in this article and hope it will serve readers better. Rather than list each candidate separately I will present all new candidates to consider in a table with each row representing one candidate including pertinent data for each. I will then list my top eight picks out of the group.

I will start with an explanation of columns with abbreviations for those who may be new to the series. Symb means symbol, or ticker for the candidate stock; wherever [Curr] is used, it means current; I use the $ to represent the word Price; I use Tar to mean target; the target price is how low I believe the underlying stock may go if our economy falls into a deep recession; where I use [Prem.], it represents the premium, or price, of the option for one share; each contract equals 100 shares; # of Cont means the number of contracts needed to protect approximately 1/8 of a $100,000 equity portfolio against a loss if the market falls by 30 percent or more; Est % Gain refers to the percent of gain for the positions relative to the initial investment if the candidate stock price falls to the target share price; Current Bid Premium is the last price at which the listed option contract was offered to be bought; Current Ask Premium is the last price at which the listed option contract was offered to be sold; the Target Premium is the price I will try to buy put option contracts for each of the candidates; % Cost of Port is the percentage of a $100,000 equity portfolio that will need to be spent to purchase the position as listed (plus commissions); Exp Mo/Yr refers to the month and year in which the option contract listed will expire.

The companies represented by their respective symbols are (in alphabetical order): Autodesk (NASDAQ:ADSK), Sotheby's (NYSE:BID), E*TRADE Financial (NASDAQ:ETFC), Goodyear Tire & Rubber (NASDAQ:GT), the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), CarMax (NYSE:KMX), L Brands (NYSE:LB), Level 3 Communications (NYSE:LVLT), Marriott International (NASDAQ:MAR), Masco Corporation (NYSE:MAS), Six Flags Entertainment (NYSE:SIX), Tempur Sealy International (NYSE:TPX) and Zions Bancorporation (NASDAQ:ZION).

Symb

Curr Sh $

Tar Sh $

Strike Price

Curr Bid Prem

Curr Ask Prem

Tar Prem

# of Cont

Est. % Gain

% Cost Port

Exp. Mo/Yr

ADSK

$59.45

$24

$47.50

$1.30

$1.40

$1.40

2

1579

.28%

Jan-17

BID

$32.39

$10

$25.00

$0.50

$1.25

$0.75

3

1900

.23%

Jan-17

ETFC

$25.08

$7

$20.00

$0.56

$0.68

$0.60

3

2067

.18%

Jan-17

GT

$28.67

$8

$25.00

$0.85

$0.90

$0.85

2

1900

.17%

Jan-17

JNK

$36.06

$28

$33.00

$0.35

$0.60

$0.45

8

1011

.36%

Jan-17

KMX

$58.26

$16

$47.00

$1.50

$1.75

$1.60

1

1838

.16%

Jan-17

LB

$73.90

$25

$63.50

$2.05

$2.15

$2.10

1

1733

.21%

Jan-17

LVLT

$50.60

$20

$43.00

$0.75

$1.15

$0.80

2

2775

.16%

Jan-17

MAR

$71.70

$30

$62.50

$1.50

$2.05

$1.65

1

1870

.17%

Jan-17

MAS

$36.48

$10

$31.00

$0.70

$0.85

$0.75

2

2700

.15%

Jan-17

SIX

$56.39

$20

$50.00

$1.10

$1.35

$1.25

1

2300

.13%

Dec-16

TPX

$75.63

$10

$60.00

$1.40

$1.60

$1.50

1

3233

.15%

Dec-16

ZION

$27.88

$5

$25.00

$1.09

$1.15

$1.10

2

1718

.22%

Jan-16

All quotes are as of the market close on Friday, July 29, 2016. I recommend that those who decide to try this strategy use a basket of at least eight options, all on different companies, for diversification. In the case of a recession, all positions may work, but some may not work as well as anticipated while others outperform. My eight top picks at the moment are GT, LVLT, MAS, MAR, KMX, SIX, TPX and ETFC. If bought as a group and as listed in the table (target premiums, expiration months and numbers of contracts), the cost would represent about 1.26 percent, or $1,260, for a $100,000 equity portfolio and would protect against an estimated $29,190 drop in value of the hedged portfolio if the broad market fell by 30 percent.

The current pricing for JNK is about the best it has been should one want to hedge a bond portfolio. Several of my original candidates have already fallen too low to offer me much downside protection. Remember, it only takes one or two positions to do well to offset much of the cost of hedging.

Discussion of Risk

I want to discuss risk for a moment now. Obviously, if the market were to rally higher beyond January 2017 all of our option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. But it is one of the potential outcomes and readers should be aware of it. The longer it is before the next recession, the more expensive the insurance may become. 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 whether the market will turn into a full-blown bear or regain the high ground and the 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 two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three 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 before a major market downturn has occurred. When the bull continues for longer than is supported by the fundamentals (which is where we are today in my opinion), the bear that follows is usually deeper than it otherwise would have been. In other words, at this point I would expect the next bear market to be more like the last two, since the market has, in my opinion, defied gravity until now. Anything is possible but if I am right, protecting a portfolio becomes ever more important.

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.

For those who would like to learn more about my investment philosophy please consider reading " How I Created My Own Portfolio Over a Lifetime, or for those who would rather listen to a podcast on the same subject, you may want to consider my interview by IITF.com which can be found here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: I own or intend to purchase put option positions in most, if not all, the companies listed in this article.