Tag Archives: market

Summary Brief overview of the series. Why I hedge. Taking profits and rolling positions. List of favorite candidates. Discussion of the risks inherent to this strategy versus not being hedged. Back to 2,753 Percent Profits on Men’s Warehouse (NYSE: MW ) Strategy Overview As I write this the S&P 500 Index is within 3.6 percent of its May record high. Are we going higher or not? Hard to say. Market internal appear to be very weak as I explained in my recent article, ” Major Indices at a Crossroads…Again ,” where I point out that just last Friday 329 (65.8 percent) of the 500 component companies of the S&P 500 were trading below their respective 200-day simple moving averages and that 37.2 percent were more than 20 percent below their respective 52-week highs. Those numbers do not paint a picture of broad strength. 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 and IV. 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 sizeable market correction. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. 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. Why I Hedge If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while) I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but have also have eliminated the big losses. It makes a significantly positive difference in the end. A note specifically to those who still think that I am trying to “time the market” or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five year period I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. Taking Profits and Rolling Positions It is that time of year again when I need to decide what to do with my current positions and how to best protect my portfolio into the year ahead. I will begin with those positions that have the largest positive values as we need to use the gains or remaining values to fund some new hedge positions with expirations further out into the future. The largest gainer of this series has been Men’s Warehouse, which was recommended in August 2015. At that time MW stock was trading at $58.49 and I bought put options with a strike price of $45 and expiration of January 2016 for a premium of $0.75. Currently MW is trading at about $18.50 per share and my options (if I still had them) are trading at a premium of $26.20. I sold my position once the shares dipped below my target of $25.00 per share. If you still hold those options as a hedge it is decision time. You can continue to hold if you expect the stock to fall further, but the payoff becomes less and less as the shares get closer to zero. At this time I do not expect the company to file bankruptcy. If you disagree you can hold onto your position. If you agree that the company is more likely to work its way out of this situation over time I would suggest not being too greedy. I have sold already. If you decide to sell today you will have a gain of $2,545 per contract, or 3,393 percent. I had bought ten contracts originally, so I am very happy with the results. I plan to use these proceeds to purchase additional hedge positions in other candidates that have much further to fall when the next recession comes. The gains from this one position will pay for my entire hedge for the next year. That is how the strategy works. It only takes being right once or twice a year for the hedge to pay for itself and such occurrences happen even when there is no recession. When the next recession finally hits most, if not all, positions will begin to work in our favor to protect us from significant losses during the ensuing market downturn. I will list a few of my favorite candidates at current prices later in this article. Another winner this year has been Micron Technologies (NASDAQ: MU ). I took nice profits from option positions that expired this summer but held onto my January contracts. I am glad I did and hope you did also. Below is a table with the month in which I recommended buying MU put options for January expiration, the strike price recommended, the ask premium as of that time, the current bid premium, the dollar amount gain per contract and the percent gain per contract. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available December $17 $0.60 $2.24 $164 273% January $17 $0.59 $2.24 $165 280% March $17 $0.40 $2.24 $184 460% April $20 $0.49 $4.65 $416 849% May $18 $0.33 $3.00 $267 809% June $15 $0.47 $1.21 $74 157% I purchased (from the October Update article) some MU put options last month that expire in April 2016 with a strike price of $11 for a premium of $0.27. The current premium on those contracts has risen to $0.39. That makes these options too costly at the current level relative to the potential gain. It is always a risk/reward trade off when choosing the right hedge positions. I intend to sell all of my January expiration positions at these levels and use the gains, if necessary, to add new positions in other candidates for future protection. Another candidate that has begun to give us some gains is Sotheby’s (NYSE: BID ). I started buying BID put options for January expiration in April. Below is a table with the results of all my January 2016 BID option recommendations. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $30 $0.50 $2.00 $150 300% May $35 $0.90 $5.70 $480 533% June $35 $.50 $5.70 $520 1,004% August $31 $0.55 $2.70 $215 390% August $30 $1.05 $2.00 $95 90% I also purchased BID put options last month with an April expiration. The contracts had a strike price of $27 and were purchased at a premium of $1.15. The current bid premium is $1.60. I plan on holding this position but selling the January 2016 contracts and using the proceeds to purchase additional hedge positions. I intend to add some January 2017 BID put options as I believe this one is likely to keep dropping to at least my $16 target within the next year as the new wealth creation machine called China continues to slow down. I will include my selections later in this article. The next candidate that is beginning its descent as expected is Williams-Sonoma (NYSE: WSM ). I have recommended WSM January 2016 puts eight times with all but two showing gains. The purchases from early in 2015 have not yet paid off. The premiums for higher strikes became more advantageous as the year went on and WSM shares rose higher. This is why I usually add only partial positions at the beginning of each year and add more positions whenever a candidate’s stock price rallies. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available January $55 $1.90 $0.90 -$100 -53% February $55 $1.60 $0.90 -$70 -44% March $60 $1.65 $2.15 $60 30% April $60 $1.85 $2.15 $30 16% May $60 $1.25 $2.15 $90 72% June $70 $1.90 $6.80 $4.90 258% August $72.50 $1.80 $8.20 $640 355% August $70 $1.90 $6.80 $490 258% I intend to continue to hold these positions until closer to expiration. WSM has exhibited weakness as of late and I expect more of the same. Each individual investor needs to consider what he/she wants to do in situations like this. However, since the cost of the hedge this year is already covered from other gains I would rather continue to hold contracts that are well-positioned for additional gains. Another candidate that has begun to struggle is Seagate Technologies (NASDAQ: STX ). I only have three open positions in STX and all expire in January 2016 and all are profitable. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $38 $0.58 $4.45 $387 667% May $35 $0.43 $2.55 $212 493% June $35 $0.52 $2.55 $203 390% This is another case of a company that could easily see further erosion by January 2016. I like the contracts with the $38 strike price the most and will definitely hold those longer. I am on the fence with the $35 strike contracts but will hold them at least until I get a better sense of whether the current weakness is likely to continue or abate. It is easier to hold positions when my costs for the next year are already covered by gains elsewhere. This remains a hedge strategy and not a trading system so keeping well-positioned contracts longer is always a good idea. If these contracts expire worthless I will try to not suffer remorse. The article is beginning to get a little long so I will continue with more about what I intend to do with other open positions in another article that I will do my best to submit by tomorrow. Now, on to the list of what I like at current levels. List of favorite candidates E*TRADE Financial (NASDAQ: ETFC ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.42 $7.00 $25.00 $.090 $1.05 1614 $3,390 0.21% I need two April 2016 ETFC put contracts as defined above to provide the indicated loss coverage for each $100,000 in portfolio value. If a recession hits, and especially if the financial markets are roiled, ETFC will take a significant hit and provide us with nice hedge protection gains to offset portfolio losses. However, I do not recommend starting a full position at current levels. We need to use volatility to our advantage. If the ETFC stock price rallies from here we will be able to lock in better positions in the future. I intend to open a partial position (about 1/3 of my intended full position) here and add more at a later date if we get a rally. This same strategy applies to all listed positions. I only need two April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. Goodyear Tire (NASDAQ: GT ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.30 $8.00 $27.00 $0.60 $0.70 2,614 $3,660 0.14% If a recession comes to the U.S. car sales will fall off precipitously and people will put off purchases as long as possible. Tires are important but when people are losing jobs or witnessing others in trouble there is a tendency to make such things last a few more months. GT share price is making new highs so now is a good time to get a healthy position. I would still refrain from taking a full position just yet as there could be additional upside to the price in the near term which should provide us with an even better entry point. I only need two GT April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. Morgan Stanley (NYSE: MS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $33.98 $15.00 $28 $0.55 $0.58 2,141 $3,726 0.174% Similar to ETFC, MS is vulnerable to financial market disruptions and I do believe that massive growth in junk bonds, both domestic and U.S. dollar-denominated foreign, represent such a potential trouble for the global economy. Again, this stock is off its high so we could potentially see a better entry opportunity in the future unless the market turns down abruptly sooner than I expect. I will add a starter position here. I only need three April 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. I intend to start with one contract as described for each $100,000 in portfolio value. Royal Caribbean Cruise Lines (NYSE: RCL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $94.25 $22.00 $65.00 $1.26 $1.41 2,950 $4,159 0.141% RCL shares have been on a tear this year, but in a recession this issue will see capacity utilization drop and margins evaporate. It happens like clockwork. RCL shares are about six percent below their respective 52-week high. One might get a better entry point but this is pretty good. I will add a starting position for 2016 and need one June RCL put option contract to provide the protection shown above for each $100,000 of portfolio value. The number of contracts indicated are for a full position. United Continental (NYSE: UAL ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $58.01 $18.00 $50 $1.96 $2.10 1,424 $2,990 0.21% UAL is nowhere near its high of the year after exhibiting weakness even in the face of falling fuel costs. A recession, in my opinion, would devastate this stock as businesses would reduce business travel for employees dramatically. I only need one March UAL 2016 put option contract to provide the coverage indicated for a $100,000 portfolio. In order to limit my purchase to one-third of a full position I will buy only one contract for each $300,000 of portfolio value. Summary As I pointed out in the article linked at the beginning of this article I believe that the market is at a crossroads. There is very little impetus to drive prices higher other than cheap money, but cheap money may be enough to keep things going a little longer. If a bear market does not show itself before January 2017 I will be surprised. Many stocks are already experiencing a “stealth” bear market and therefore I believe it is prudent to make prudent hedging decision for 2016. I would like to extend the expirations on contracts more than I have for more extended coverage but the open interest/volume is not yet high enough to wade into those contracts. That should change over the next few months and I will be ready to add more positions as it happens. That is one of the primary reasons why I have tried to emphasize that I am only adding partial positions at this time. I will do my best to submit another installment for this series tonight (Wednesday) for publication on Thursday. In that article I will attempt to include the remaining outstanding positions and what I intend to do with them. Going forward I want to write more often about this strategy for two reasons. The first is simply that is seems the global economy is nearly ready to fall into a recession and growth in the U.S. also seems rather stagnant. If profits continue to fall year/year as happened in the third quarter it may portend the beginning of the next recession. Retail sales and profit margins may prove to be the most important measure of the health of the consumer and, by extension, the U.S. economy. The second reason is that I would like to publish whenever I see a good entry point in one of the candidates or when I identify another candidate immediately instead of waiting for a monthly update. I hope these changes will be beneficial to readers following the series. Brief Discussion of Risks 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 approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our old January expiration 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. 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. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market the more the insurance is likely to 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 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. 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, at this point I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible but 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.