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Summary Overview of strategy series and why I hedge. Why not gold? The profits I plan to take now, and what I am doing with other unrealized gains and losses. Some new positions to consider. Discussion of risk involved in this hedge strategy. Back to Update on Bond Hedge 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 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 merely 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! 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, both financial and emotional. 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 to accomplish than doubling a portfolio, and takes less time. Trust me, I have done it both ways, and losing less puts me way ahead of the crowd when the dust settles. 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, in my humble opinion. 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 when they should be getting ready to buy. Why Not Gold? Gold can be a great hedge against inflation and in times of crisis, especially if the crisis is expected to lead to inflation. Notice the theme of inflation? Currently, we are in a deflationary economic environment. If you do not believe that by now, I probably cannot convince you otherwise, but I will try just the same. Trillions of dollars, yen, euro, and many other currencies have been created around the world via quantitative easing, yet almost no inflation exists. During and since the Great Recession, many governments around the globe injected trillions more into their respective economies to stimulate growth, yet growth has been anemic. Interest rates are at historically low levels (some yields have even turned negative) due to, once again, central bank intervention and lack of demand for loans; still, inflation and growth in most economically developed countries remain well below expectations. The world has never before experienced the level of coordination between central banks with such accommodative policies, all focused on an attempt to create inflation. Yet, all efforts are failing. Without all the record-setting central bank and government interventions, the global economy would be experiencing deflation. How could it be otherwise? If that is not true, then why are central banks trying so hard (and failing) to create inflation? I respectfully submit that I believe much of the developed world economy is in a deflationary economic environment. But why is that so? Many will argue that demographics is the culprit leading to reduced demand. Others will contend that too many companies have built more capacity than is needed to meet current demand, even though demand continues to rise. In other words, demand just is not rising fast enough to absorb the excess supply flooding the globe. I suggest we are suffering a little from both: sluggish demand due to changing demographics and excess supply and capacity in many industries that overbuilt infrastructure to accommodate the expected continuation of growth by China and other emerging markets. The growth slowed and created excess supplies in a lot of areas; most notably, energy, minerals and maritime transportation. At the same time, large portions of developed nation populations are aging, retiring from the workforce and spending less. At the same time, younger people entering the workforce are finding fewer good-paying jobs available, while many are saddled with large student loans that will eat into their abilities to increase spending for several years. Both ends of the demographic spectrum, especially in the U.S., point to a slowing growth in demand. And with excess supply and capacity issues, companies are less likely to invest heavily in additional plants or equipment, again leading to slowing demand. So, how do I expect the price of SPDR Gold Trust ETF (NYSEARCA: GLD ) to react during the next recession? I will use pictures (graphs) to explain my opinion. Feel free to disagree! GLD data by YCharts GLD shares hit a high of just over $100 in March 2008. By September 2008, when Lehman Brothers fell into bankruptcy, the GLD share price had fallen to $66. The initial reaction to the financial crisis was not positive. GLD data by YCharts This next chart shows us how GLD reacted to all the initial government and central bank intervention efforts. There was much speculation at the time that all that deficit spending, the near-zero interest rate policy and quantitative easing would lead to massive inflation. Of course, GLD rallied! Expectations for inflation drove demand for assets that could thrive in an inflationary environment. GLD data by YCharts The final chart shows us what happened when a majority of investors decided that inflation was not coming after all, and that central bank policies indicated that deflation was the real enemy. As of Friday, December 18, 2015, the price of GLD is at $102.04 and continues in a downtrend. Unless the next recession occurs as a result of an event that is expected to lead to inflation, I believe GLD shares will continue lower, at least after any initial reactionary rally fades and reality set in again. Deflation is still the enemy most feared by central banks, and until it is conquered, GLD will not provide the safety desired. Of course, that is only “my” opinion, and if you disagree, please feel free to follow your own convictions. I hold a few bags of silver coins that I accumulated over time since I was a teen. But the value of my silver holdings represents a very small portion of my portfolio. In case you think me a hypocrite, understand that I am not relying on my pittance of silver to save me in the next market meltdown. I confess that I do not know when inflation will return, although I do expect it to do so at some time in the future. It always does. Then, those coins will be worth something, and I could sell if I need the money or wish to convert it to cash. Right now is not a good time to do so. I invest for the very long term, so movements over the next year or two, or even five, have no impact on my long-term goals and expectations. The profits I plan to take now I want to start off this section by explaining why I intend to take profits on some positions and not on others. First, I would rather realize (sell) positions that have substantial gains already to make sure I do not lose that opportunity. I will use the proceeds from those positions to buy more hedge protection using other candidates with more future potential. But I do not like the pricing of most options available in the market today. So, I will continue to hold some of my positions with smaller gains in order to keep at least a partial hedge intact. I also intend to hold any positions with losses at current levels in case the market falls further. This provides two possible outcomes: we may need to stay protected if the market correction we are now experiencing turns into something far worse, in which case we can roll these positions later when there is a gain available; if the market rallies or remains relatively range-bound, we will allow those positions to expire worthless. Remember, this is insurance against catastrophic loss, not a short-term trading strategy. Of course, anyone who wishes to continue to hold the positions I intend to sell may also experience even higher gains, or conversely, they would risk losing most, if not all, of those gains should the market rally to new highs. All quotations used in this article are from the close on Friday, December 18, 2015. I intend to execute my sales on Monday, and may do somewhat better or worse than what could have been achieved on Friday. If the stocks of the companies I plan to sell open lower, my profit will probably be higher, and conversely, if the price of the stock goes up on Monday, I will probably realize a smaller gain. However, to stay conservative, I use the bid premiums from Friday, and the reality is that I should be able to sell for a little more than that if the market were to remain flat. The first candidate I want to mention is Men’s Wearhouse (NYSE: MW ). If you have not already taken your gains to fund next year’s hedge, I suggest you do so now. The underlying stock has already fallen from $58.28, when I first recommended buying puts in August, to a current price of $14.63. My put option contracts that expire on January 15, 2016 with a strike of $45 are currently trading with a bid of $27.10. I bought two contracts for every $100,000 of portfolio value I wanted to protect for $75 each. Those two contracts are now worth $5,420, for a gain of 3,513 percent. Do not be greedy! There is not much more potential gain left between now and the expiration. I want to use those proceeds to buy new positions with greater potential that expire mid-year in 2016. These proceeds alone should more than cover my hedge for all of 2016. Next up is Micron Technologies (NASDAQ: MU ). Those of you who have been following this series for more than a year will remember that I took some nice profits this summer on MU puts that expired in July 2015. My gains then varied, based upon when I purchased, what strike price we used and what premium we paid from 397% to 878% . Now I hold MU puts that expire in January with varying gains. The contracts that I bought in April and May with strikes of $20 and $18, respectively, will now yield returns of 1,012 and 945 percent. I could capture a little more, but why risk it? I paid $49 each for four contracts in April for each $100,000 I wanted to protect, for a total of $196. I want to sell these now at the current bid premium of $545 each, or $2,180 total. I will also sell the five contracts purchased in May at $33 each (total hedge cost of $165) for $345 each, or a total of $1,725. These two positions will give me back a total of $3,905 (for each $200,000 I was protecting with two positions) that I can now use to hedge into 2016. My proceeds from this hedge will also be enough to cover most, if not all, of my 2016 hedge costs. I still have more profitable MU positions purchased with lower strike prices, and will continue to hold those to expiration to maintain some protection, should the market fall further before January 15th. My third sales will be of my April purchase of puts on Seagate Technologies (NASDAQ: STX ) that expire in January 2016 with a strike price of $38. I bought three contracts for each $100,000 of portfolio value I wanted to protect for a cost of $58 per contract (total $174), and will sell for the current bid of $390 per contract (total $1,170), for a gain of 572 percent. I will address what I intend to do with my other STX positions in the next section. Sotheby’s (NYSE: BID ) has been good to me this year! I made purchases in May and June of BID put contracts for January expiration with strikes of $35 and a purchase in August at $31. The gains on each are 789, 1,500 and 645 percent, respectively on those positions. The total cost of those three positions (each of which was designed to protect $100,000 of portfolio value) was $445. The total proceeds will be $4,430. Again, these proceeds could cover my hedge expenses for 2016, so now I have plenty to fund my strategy into the future. The final positions I plan to sell now are those I bought during June and August in Williams-Sonoma (NYSE: WSM ). I made one purchase of one put contract for January 2016 of WSM with a strike price of $70 in June for $90, and plan to sell it at the current price of $1,090, for a gain of 474 percent. I made two purchases in August – one put with a strike of $72.50 for a premium of $180, and one with a strike of $70 for $190. The current bid on the $72.50 strike contract is $1230, while the other contract is bid at $1,090. The total cost of both contracts was $370, and the total proceeds will approximate $2,320, for a gain of 527 percent. So, what if you did not make the purchases listed above? I will explain what I plan to do about those position in the next section. What I am doing with other unrealized profits and losses First, for those positions with little or no value, I plan to hold those to expiration. If some still have more than $5 of value on the last day, I will sell those positions as long as I can net more in proceeds than the cost of commissions on the sales. Since I have all the gains that I need to fund the next year of hedging, I intend to hold all other positions until near expiration to maintain at least partial protection from further market volatility. I will use the same selling strategy as mentioned in the above paragraph at expiration or during the week leading up to it. But for those who hold positions with small gains that missed out on the big gains listed in the section above, you will need to decide whether to hold on in case equities fall further or to sell some positions to help offset the cost of your 2016 hedge positions. Last year, I only took profits on one position (Terex (NYSE: TEX )) and could offset only a portion of the strategy costs. Do not forget that hedging is a form of insurance, and insurance is rarely free. I got lucky in 2015 and hope I can get more new positions in place before I might need them in 2016. Some new positions to consider I am not recommending or making any outright purchases at this time. However, there are some positions I would like if the premiums come back down enough to meet my criteria. I do not know if we will have a Santa Claus rally this year. It happens during the latter half of December about 72 percent of the time. I would not mind one this year (or any year, for that matter). It would provide more opportunity to position my portfolio for 2016. The bottom line is that I try to keep the cost of my strategy low and also try not to pay too much for the positions I want. However, as we move further along this path, I am willing to pay a little more for a higher strike price than I was at the beginning of the series. This is only my third attempt to use this strategy, and the first in which I am trying to be fully hedged. I hope we are all learning together and getting better as we grow in experience. It has worked for me in the past, but on a smaller scale. So far, I am happy with the outcomes and hope to keep improving the results in the future. Do not forget that I usually buy multiple positions in each candidate that I use, and you should, too, unless you get in at a particularly good premium and strike. I add positions as I find I can do better than what I already own in order to improve my overall hedge. Sometimes, I may buy only half or a third of the position I intend to own in the first purchase. As we get deeper into this bull market (if it still is a bull), I try to stay closer to fully hedged as much as possible. Here is the list of what I would buy next, and the premiums at which I would make the purchases. I may get in if the premium gets down close to my buy price, and you will need to make such decisions for yourself. I really get frustrated when I miss buying a position over a nickel or dime on the premium. It is not worth the risk of being unhedged. Symbol Current Price Target Price Strike Price Ask Prem. Buy At Prem. Possible % Gain Tot. Est. $ Hedge % Cost of Portfolio RCL $95.90 $22 $75 $2.58 $1.80 2,844 $5,120 0.180% MAS $27.88 $10 $25 $1.35 $0.80 1,775 $4,260 0.240% GT $31.87 $8 $27 $1.30 $0.85 2,135 $3,630 0.170% KMX $53.49 $16 $50 $3.90 $2.50 1,260 $3,150 0.250% ADSK $59.52 $24 $50 $2.43 $1.75 1,633 $4,900 0.300% SIX $52.58 $20 $45 $1.65 $1.25 1,900 $4,750 0.250% To protect one-eighth of a $100,000 equity portfolio, I would need the following number of contracts to provide the estimated hedge protection shown above. The total cost of the above positions would be about 1.39 percent of my portfolio to hedge 75 percent of 100,000 value. Royal Caribbean Cruise Lines 1 Masco 3 Goodyear Tire & Rubber 2 CarMax 1 Autodesk 2 Six Flags Entertainment 2 Please note that each position is designed to protect only 1/8th portion of a portfolio value of $100,000 against a market drop of 30 percent or more. The number of contracts provides total estimated gain shown in the first table if the stock price hits my target price. For additional explanation of the strategy, I refer you to the first article in the series (follow the link in the first paragraph of the article), which contains a detailed explanation of the strategy and how it works. I expect the stocks listed above to fall precipitously during a recession, as each has a history of doing so during past recessions, and many have fallen much further than the overall market during the last two meaningful market swoons. Discussion of risk involved in this hedge strategy 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 to 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 accomplish this I generally add new positions at the new strikes over time, especially when the stock is near its recent high. 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. In 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 ensure 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 five 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.