Taking 700 Percent Gain On Tempur Sealy Hedge Position

| About: Tempur Sealy (TPX)
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Strategy overview and why I hedge.

Taking a 747 percent gain on my Tempur Sealy hedge position.

A brief discussion of the risks inherent to this strategy.

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

Back to Sell L Brands February Position

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 provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. Many of the series articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizable 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. But I do not hedge all the time. That would be counterproductive. 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. During 2015 and early 2016 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 had plenty left over to extend my hedge well into 2016. This is how I keep the cost of hedging low but my portfolio remained fully hedged against loss. Now, as I prepare for 2017, I am dipping into my portfolio again to cover the cost of my new hedge positions. For a full accounting of the results from last year and a summary of 2014 and 2015 please refer to this article. I am working on a summary of 2016 results to be published in the next day or so and will include a summary of results since inception.

I have a larger than usual cash position but continue to hold onto my core, dividend-paying portfolio. If the market moves to new highs and I miss a portion of the next ten percent move higher but 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 knowing that I will kept my portfolio intact, continue to collect my dividends and have plenty of dry powder ready to deploy when the best bargains once again become available. 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.

Action to Take Now!

I am selling my March put contracts that expire on Friday, March 17, 2017 today on Tempur Sealy International (NYSE:TPX) to take a nice gain. I wrote about the purchase of these option in September 2016. The target premium listed in that article was $1.70. It was trading with a bid of $1.65 and asking $2.80 at the time and the underlying stock price rose within a week making entry at that premium (or even better) possible. Those contracts are now trading at a last price of $14.40 ($13.90 bid; $15.10 ask). I believe I should be able to sell at the last $14.40 premium in my sale which will provide me with a gain of $12.70 per contract or 747 percent (excluding commissions).

Let me explain the reason I am selling now instead of waiting until closer to expiration. TPX lost a distribution contract relationship with Mattress Firm (its largest customer) that accounted for 20 percent of TPX sales. The company will take steps to make the loss seem more palatable to shareholders but, in the end, it means that future revenue and earnings will fall and that the excess capacity may need to be shuttered. It may be that the company could reduce headcount, work less shifts and keep all factories open but, unless TPX can find new customers to fill that void soon it will inevitably lead to lower margins on lower sales due to increased costs per unit.

But there is always a hope that the two companies can find common ground and announce a new deal. If that happened, both companies would make big announcements spinning the new arrangement a mutually beneficial and TPX stock would rise. In the meantime, the overall market is still trending higher due to expected policy changes from the new administration in Washington. A rising tide lifts all boats. TPX stock has taken the initial hit and will probably trade sideways for the next month or so, or until it can either announce a new customer acquisition, a new deal with Mattress Firm, or it next quarterly results. Holding onto the position for the next 30 days is more akin to rolling the dice. I would rather take the gain (bird in the hand) now than hope for more and potentially be forced to accept less.

To be clear, I do not consider this a trading gain. It is merely a reduction in the cost of hedging when taken against the losses on other positions that did not do as well. Mine is not a trading strategy. It is simply a low cost method of insuring against catastrophic losses when the next recession occurs.

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 my option contracts that I 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.

When the next crash does happen I will be relying on a tool I found to be very useful in identifying the best bargains available at any given time. It is called Friedrich. I use it to highlight valuations in some of my other articles as I find it comes very close, in most cases, to my own valuation model results and takes me a lot less time. It is also going global, so I am excited about being able to scour most of the globe in search of value. When the USD finally does peak in value relative to other currencies I will want to invest more of my portfolio carefully in foreign based stocks to take advantage of the positive currency movements in the future. Value is value no matter where we find it.

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. Don't forget to hit the "FOLLOW" button at the top of the article next to my name to keep up to date on my next moves and full accounting of results for the strategy.

For those who would like to learn more about my investment philosophy please consider reading " How I Created My Own Portfolio Over a Lifetime.

Disclosure: I am/we are short TPX.

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: My short position in TPX consists of owning put option contracts. Important Note: This article is not an investment recommendation and should not to be relied upon when making investment decisions - investors should conduct their own comprehensive research. Please read the Disclaimer at the end of this article. Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment, tax, legal or any other advisory capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice. The author explicitly disclaims any liability that may arise from the use of this material.