The Time To Hedge Is Now! 700 Percent Profits On Men’s Wearhouse
Summary Introduction and a brief overview of the series. 700 percent profit since August. Taking profits or riding a little more? Discussion of the risks of employing this strategy versus not being hedged. Back to Bear Rally = Another Chance! Introduction and Series Overview 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 an inexpensive 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. 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 (nearing 82 months) than all but two bull markets during that time period (out of a total of 15). The three longest bulls prior to this are 1949-1956 (70 months), 1921-1929 (97 months), and 1990-2000 (117 months). 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 earlier than I suggested at the beginning of this series. I feel confident that the probability of experiencing another major bear market continues to rise. It may have started already or it may not come until 2017, before we take another hit like we did in 2008-09. But I am not willing to risk losing 30-50 percent 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 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. 1220 percent profit since August I originally recommended buying puts on Men’s Wearhouse (NYSE: MW ) back in my August Update to this series. The stock was then trading at a price of $58.49 per share. Friday, after the company slashed its outlook for the current quarter on weaker-than-expected sales, the shares closed at $22.65 per share. In August I recommended buying two put options expiring in January 2016 with a strike price of $0.75 or less for each $100,000 in equity portfolio value. The bid premium at that time was $0.55 and the ask premium was $0.75. If one was patient it was possible to buy those put option for even less that the $0.55 bid premium not long after the article was published. Today, those MW $45 put options are trading at a premium of about $6.00. If we assume the worst case scenario of buying the put options at the ask premium of $0.75, then the profit that is available today is 700 percent [($6.00 – $0.75) / $0.75]. My target price of $25.00 was achieved. Thus, I am suggesting that those who ventured into this positions at my earlier recommendation consider what to do next. This one is likely to continue to be very volatile for the next few days and weeks. Taking profits now or riding a little longer? There may be more profit available, but sometimes it does little good to get greedy. The stock could just as easily rebound next week and leave us wishing we had taken profits. However, it should be noted that if the stock were to remain at this level through the January 20th expiration date, the value of the put option would rise to $22.00. If the stock rebounded by 25 percent between now and then, rising to about $28.50, the options should expire at about a $16.50 premium for a potential profit of 2,100 percent. There is a tradeoff to be considered. Do we take the profit now and cover the cost of our other hedge positions or do we hold onto the position to maintain the insurance coverage and hope that the stock remains depressed for 2½ months? That is a decision each investor needs to make for themselves. For my own portfolio, I intend to take some of the profits on part of my position and let the rest ride. My sense is that MW could linger below $30 until January unless management guides higher due to increased holiday sales. But such an announcement is not likely to come until mid-December or later, so there is still plenty of time to weigh our options (pun intended). I want to emphasize that this strategy is not a get rich quick plan. It is a hedge strategy to provide insurance against a major bear market. When I have the opportunity to take some profits and reduce the cost of my hedging strategy, I will often take at least some of what the market gives me. When one of our candidates implodes as MW just did and like MU and TEX did for us previously, it is prudent to take advantage of situation. I have tried to be clear from the beginning that the strategy has the potential to cost less than one percent of a portfolio value per year for this very reason. Any one of the candidates has the potential to surprise big to the downside over the life of the hedge, thereby helping to offset part or all of the cost of the hedge in any given year. It only takes one good plunge surprise to pay for the most of the cost of our total hedge for a year. The MW situation is just one more example of how that works. 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. To build such positions one would need to follow future articles as I provide the best option contracts on the best candidates each month. I build my own positions from the positions listed in the articles. Discussion of the risks of employing this strategy versus not being hedged. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our earlier option (except JNK ) contracts could expire worthless. I am not ready to roll positions yet, but will probably when the open interest on contracts expiring in May, June and July have reached at least 50 or more. We need some liquidity to be able to move in and out of positions when necessary. 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 July 2016 or January 2017, using from one to two percent of my portfolio to hedge for another year. The longer the bulls maintain 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. Mine is a unique hedging strategy. But it is not the only hedging strategy that can work. Each investor needs to consider which strategy makes the most sense for their own purposes. The main reason I am writing these articles is raise the awareness of investors that hedging is a prudent part of an overall investment strategy. One does not need to be hedged at all times; that would be overkill and far too expensive. But when the equities market has been hovering at all-time record highs for months and the bulls have been in charge for as long as is the case in the current environment, investors need to consider whether they can stand another bear market without protecting against those losses. 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) to insure against losing a much larger portion of my capital (30 percent or more). But this is a decision that each investor needs to make for themselves. I do not commit more than two 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 five years instead of two or three). 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 expect a correction greater than the original 30 percent that I originally forecast. If the next recession does not begin until the second half of 2016 or 2017, 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.