How to Hedge Your Virtual Portfolio
Options Sage submits:
In our comment section this past Tuesday, Turtle referred to Warren Buffett’s Rule #1 of investing: “Don’t lose money” and pointed out the integral link between succeeding at Rule #1 and hedging one’s virtual portfolio. The question arose “How do we hedge our virtual portfolios?”
In order to set a context for explaining strategies let’s briefly revisit the Golden Rule of Investing.
The Golden Rule of Investing
“The more uncertain you are about a position, the more you should hedge your position!”
This might be worth sticking right next to Phil’s post-its that state:
“It is NOT my Job to Save the Market”
and:
"When in Doubt – Sell Half"
Before we figure out how to hedge, let’s evaluate how certain we are of the current direction of the market. On Monday Phil posted links to an article on record margin debt in January of $285.61B surpassing even the March 2000 highs and he was very concerned that the SEC’s solution to this was to relax the margin requirements, which could lead to a 1999-like crisis.
On Greenspan’s remarks "We have extraordinarily low risk premiums now. Risk is no longer perceived as major risk, at least as it was in years past and that, I must say, I find disturbing," he said. "We do not and cannot look into history without being very concerned when you see the absence of awareness and concern about risk that we see today." Phil commented:
Let’s see if that can perk up the old VIX!
And within 24 hours, the Wall Street Journal headline screamed:
“Shanghai’s 8.8% Tumble Slams Markets”
Followed closely by VIX rocketing higher from an open of 12.12 to a close of 18.31 (up 64.22%) as the Dow dropped 416 points (-3.29%), the NASDAQ 96 points (-3.86%), the S&P 50.33 (-3.47%) and the NYSE 342 points (-3.63%). (note to readers: Phil doesn’t cause these things, he just predicts them!)
When markets drop precipitously, traders generally fall into one of three categories;
[1] Panic sellers, [2] Knife catchers and [3] Hedged traders.
Panic sellers usually attain instant relief as fear overwhelms them, knife catchers usually experience prolonged pain as hope and greed outweigh fear while hedged traders usually operate at that intersection between greed and fear; they’ve seen it all before and nothing riles them – that’s us (in theory!).
Trying to time your entries and exits correctly is always a guessing game. Here’s a nice video discussing some chart patterns you can look for to identify fear and greed in the markets.
Since our virtual portfolios are always hedged (even what Phil calls unhedged this weekend is far more hedged than 80% of the virtual portfolios I analyze) we have much less fear of the market no matter which way it moves – that’s how Phil managed to close out 10 huge winners in the Terrible Tuesday’s Wrap-up, taking 1/2 of 12 oil puts off the table while still maintaining 20 full put positons in addition to the 12 half positions (and, of course, we know he used that cash to buy new puts the next day).
Obviously after such a significant market correction, fear is paramount, uncertainty is at a peak and hedging should be a trader’s top priority because as Phil mentioned:
“Nobody wants you to get out of stocks, not your broker (he wants the commissions), not the media (if you don’t have stocks, why watch CNBC?), not the analysts (same ratings issue) and not the newsletter writers who want you to keep in the markets and keep up the subscriptions.”
Being "diversified" by sector is not really hedging – sophisticated hedging is the secret to a REALLY successful year because it means you can never violate "The Cardinal Sin of Investing" (Putting all your eggs in one basket!).
HOW TO HEDGE
Prudent hedging starts with prudent risk management. Most virtual portfolios are appropriately biased bullish over time but can be segmented into three different sections:
-
Conservative Strategies
-
Moderate Risk Strategies
-
Speculative Strategies
[1] Conservative Strategies
Conservative strategy applications include managing risk through relatively safe stock positions that can be scaled into through dollar cost averaging over time and have very strong fundamentals (low P/E multiple relative to earnings growth rate, accelerating revenue and earnings growth, low debt, high cash levels etc). Dollar cost averaging INTO a position is good but do not mistake the concept for an endorsement of adding to your losing stock positions on the way down, as many brokers may advise.
In addition, highly conservative investors may determine that long-term put options are warranted to mitigate risk to a further degree (similar to KMP trade). This is about as safe a trade as the market offers without resorting to bonds or some fixed income investment because the risk is fixed to a pre-defined limit and calls can be sold at regular intervals to further reduce risk. This is an application of the Collar Trade.
In summary,
- Dollar Cost Averaging into Fundamentally Strong Stocks
- Collar Trades
[2] Moderate Risk Strategies
Moderate Risk Strategies may take the form of some of Phil’s favorite trades such as LEAPS call options on fundamentally strong stocks as long-term income producing plays while selling call options as regular intervals to generate that income.
A step beyond this approach is to add LEAPS put options to the trade and sell put options at regular intervals to generate even more cash! For this we are looking for a stock that trades in a channel. Phil had been using DIA June puts and calls for this exact purpose for the last 3 months. Since he predicted a drop this month, he chose not to sell puts this round and exited that leg of the spread with a huge (169%) profit.
Today, the indexes look too dicey and Phil has decided WMT (currently at $47.81) is likely to stay between $45 and $52.50 for the next 3 months:
Buying WMT Jan 09 $55s for $3.40 AND Jan 09 $45 puts $3.30 (total cost $6.70)
Selling WMT Apr $50s for .50 AND Apr $47.50 puts for $1.10 (total income $1.60)
Effectively the bet is biased positive that this stock will finish between $47.50 and $50 by April 20th. As long as the stock does not move more than $1.60 past the strike ($45.90 – down 4%, $51.60 – up 8%) we will make some profit. Should we collect the entire $1.60, we will have made 24% on our investment by selling 42 of the 687 days (7%) worth of premium we own.
So, in just over 6 weeks we take in approximately 24% of the value of our long options and benefit from the higher time decay in the shorter-term options (much like our SHLD play, which is already up 50%). This process can be repeated all the way through to January 09 where we will have almost surely paid off the cost of the long options through short call premiums and can still benefit from any moves in stock price between now and then!
The danger in this kind of trade is the stock rapidly rising or falling, forcing you to possibly buy out your short option holders at very high prices (this happened to us in January with ANF). While not as profit optimal as our long-term virtual portfolio, where Phil make one directional spreads based on his selections, hedged plays like the one above are a good way to get your feet wet as you get used to the concept.
Other strategies such as bull puts, bear calls, bull calls, bear puts, straddles, strangles and calendar trades fall into this category and we will get into each of these plays as the weeks roll on.
[3] Speculative Strategies
Speculative Strategies include shorter-term plays that Phil discusses on a daily basis. These usually take the form of momentum plays with set technical targets in mind and usually are nothing more than directional long call and/or long put positions. The trick (and it’s a big trick) is to find the right mix of puts and calls across sectors and time frames to protect your income at risk without putting yourself into a position where you can’t make a profit, no matter what the market does.
Of course, that’s what we try to do every day as we add to and subtract from our positions…
Have a fantastic week!
Yours truly,
Options Sage
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