I am writing this updated version of Part III because the initial article is behind the Essentials firewall and I want readers to have this reference as part of the series. The first article included one candidate for hedging, which classified it as a focus article. So, to avoid that issue, I have left that part out of this version and updated the dates. As pointed out in many of the articles in this series, it is important for readers to understand the strategy and how to apply it in their own investing, should they decide to do so. This requires reading Parts I, II, IV and X (and III for those who need the basic tutorial on using options).
In the first article of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses from 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 selection process and an example of how it can help grow both capital and income over the long term because it allows investors to continue to hold long-term equity positions. What I didn’t provide yet was a basic tutorial on options contracts, which I believe is necessary to make sure readers understand the basic mechanics and correct uses, as well as the risks involved. Options used for speculation can be very risky. In this article, I will provide the options tutorial.
Why I Hedge
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.
What could cause the next recession? There are plenty of indicators that we can use to point to the market going either up or down, but the big one on everybody’s radar is the U.S./China trade war.
This is already the longest of all bull markets in history for the U.S. The current bull market has now surpassed ten years in length. So, I am preparing for the inevitable next bear market. I do not know when the strategy will pay off, but experience tells me that we are getting closer to the day when we will need to be protected. I do not enjoy writing about down markets, but the fact is they happen. I don’t mind being down by as much as 15 percent from time to time, 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 won’t make much sense and could sound more like speculating with options. That is absolutely not my intention. Now, I will proceed to explain the basics of options.
Basics for Options
Options Basics for American-style option contracts (there are also European-style options, which we are not using for this strategy).
There are two types of options: calls and puts. When an investor buys a call option contract, s/he has the right, but is not obligated, to buy 100 shares of a specific stock at a predetermined price (the strike price) at any time prior to the option contract expiration date. When an investor buys a put option contract, s/he obtains the right, but is not obligated, to sell 100 shares of a specific stock at a predetermined price (the strike price) at any time before the expiration date of the option contract.
When an investor sells an option (without having first purchased them), s/he is actually creating a security that did not exist before. This action is also called writing an option. When writing an option contract, the seller is providing to the buyer the right to buy or sell 100 shares of the underlying stock at the strike price any time prior to the option contract expiration date. If the buyer of an options contract does not execute the option prior to expiration, the contract will expire worthless and the seller will keep the premium paid.
When someone sells a call, they are agreeing to sell to the buyer of the contract 100 shares of the underlying stock at any time prior to the option contract expiration date at the strike price, but only under two circumstances: if the buyer executes their rights under the option (the phrase used to describe this action is often referred to as “calling away the stock”) or if the stock price is above the strike price on the expiration date. In the latter case, most brokerages will complete this transaction automatically. It is important to note at this point that I would never recommend selling/writing naked calls (meaning writing calls without owning the underlying stock) because of the level of risk which is associated with such a speculative position.
When someone sells a put, they are agreeing to purchase from the buyer of the contract 100 shares of the underlying stock anytime prior to the option contract expiration date at the strike price, but (once again) only if the buyer executes his/her rights under the option contract or if the price of the underlying stock is below the strike price on the expiration date.
The price of each option contract is called the premium and is listed as the price per share. Each standard option contract represents 100 shares. Thus, the full price paid or received by the buyer and seller of each contract is the price/premium multiplied by 100. Example: one put option contract on Applied Materials (AMAT) with an expiration of October 18, 2019 and a strike price of $30 has a premium (as of the close on May 24, 2019) of about $0.60. Since the contract represents an option on 100 shares of AMAT, the actual price per contract is $60.00 ($0.60 x 100), plus commissions of under $10 per contract. Commissions can vary widely depending on which brokerage one uses, and the $10 example is on the high end.
The premium/price of an option can be either in the money or out of the money. A call option is considered in the money when the price of the underlying stock is above the strike price of the option. Conversely, a call option is considered out of the money when the price of the underlying stock is below the strike price of the option. The premium/price of a put option is considered in the money when the price of the underlying stock is below the strike price of the option. A put option is considered out of the money when the price of the underlying stock is above the strike price of the option.
Investopedia has an article that explains the basics of options well, and also has another nice article that explains the components of an option price: intrinsic and extrinsic values. I suggest you read these articles before beginning to implement this or any other options strategy.
I need to stress that I use options only as part of a strategy. In this series, I am explaining one way of using options to protect all or a portion of the value of an equity portfolio. I also use options in other strategies around the edges to enhance income from my "buy-and-hold" portfolio. But I will stick to only the strategy of protecting your portfolio for this series.
The strategy I use is not a hedge in the strict definition of the term, rather it is a method of offsetting losses with gains when markets go down. I prefer to hedge against overall market downturns at much lower cost than traditional hedging strategies.
Considering the Risks
I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2020, all of my option contracts could expire worthless. I have never found insurance offered for free. I could lose all my initial premiums paid plus commissions. If I expected that to happen, I would not be using the strategy. 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 out to January 2021, using from 1% to 2% of my portfolio to hedge for another year. The longer the bull maintains control of the market, the more the insurance will cost me on an aggregate basis. 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 3% 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 another 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 2019; but if the bull can sustain itself beyond much that, 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. 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.
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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: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.