What color is your parachute?
If your answer to that question is: "what parachute?" then we need to have a serious talk…
Anyone can jump out of a plane, you open the door and jump – this is not brain surgery. The trick is not to die in the process! Gravity is a nasty, royal bitch and has been successfully conquered by exactly none of the approximately 100Bn people who have ever lived. Of the 94Bn people who have died, only one is even rumored to have come back so generally, when jumping out of planes, we find it advisable to employ some sort of safety device commonly known as a parachute.
Yet when we buy stocks and calls, why are we are tossing our money into the air and yelling "Fly, fly!" with no actual plan as to how to save our investments should that flying thing not work out?
Sage just wrote a wonderful article about hedging, this is akin to preparing for your jump by packing your chute, checking your straps and cords and making sure everything is in order before you go check to see if you will be the first person who ever actually flew (and if you’ve jumped out of a plane, you know you thought about it the first time). So I urge you to read that article and take the advice to heart for the next time we try to make our money fly but this isn’t an article about that. Today we have advice for the unprepared.
The prepared don’t need our help, they have a chute and a backup chute. They’ve praciced on the ground and they’ve tandem jumped with an instructor and they’ve had a few practice runs with automatic chute deployments until they got comfortable determining how much freefall they could safely handle before pulling the cord. Even with all this training and preparation, most reserve parachutes still have an automatic activation device (what we call a hard stop) which trigger before they fall below the safety zone (2,500 ft).
All this hard work and preparation keep all but around 30 of the 166,000 people who jump out of planes with parachutes each year from dying (no safety system is flawless) – this is a vast improvement over the 100% fatality rate for people who jump out of airplanes without a safety device.
So whether we didn’t have a chute at all, or whether it failed to deploy or whether, like me, we thought we were close enough to the ground last Friday and cut our primary chute away… We are all in the same boat now so let’s take a nice, rational step back and assess the situation.
- We are falling. Seems obvious but did you really accept that fact last week? If so, what are we doing with long positions?
- We don’t know how far down the ground is.
- Global investors who jumped with us are falling hard and fast.
- We would like to try not to die (again, obvious but what are you doing about it?)
If your parachute fails to deploy at 2,500 feet, you would consider yourself lucky to walk away with 2 broken legs and a ruptured spleen right? How about if you lost an arm? A leg? Some fingers??? It’s morbid but if you are looking at your virtual portfolio right now you have to think about it that way. You’ve already broken a leg or two, are you prepared to risk loss of life and limb as well?
When an animal is caught in a trap it might chew it’s own leg off to escape, finding freedom at a cost preferable to death. We can make a similar choice with our virtual portfolios today, cutting our losses and heading back home to lick our wounds.
Since we are not animals though, we can also think our way out of the situation. As a tree skier, I can tell you that I have willingly sacrificed badly sprained arms (twice) and fingers (3) and one dislocated shoulder and one torn calf to protect my head and face at various times. We all have to make decisions under stress and we have to balance out the risk/reward profile against the situation at hand (your face heading right for a redwood, for example).
So we are in freefall and we’re not sure where the ground is and we don’t wish to cut our losses and go home – what can we do?
Assuming you still like your positions and have a reasonable, rational, realistic expectation that they may come back we could spend a little money on a mattress play. In a mattress play we will take a look at our total virtual portfolio (let’s say $50,000) and decide how much more we can stand to lose (lets say $5,000) before we opt to start chewing our legs off.
Take that $5,000 right now and start cushioning your landing. If you hold 2,000 shares of stock with an average price of $25 each then a 10% drop in the market will cost you $2.50 per share. If you hold options it is much trickier as you would need to determine your time value and volatility in addition to the directional move so we’ll stick to the more straightforward example. What we do in either situation is start buying mattresses and stacking them on top of each other, the further we fall, the more mattresses we buy to cushion our landing.
You can protect your 2,000 shares of stock by purchasing 20 April DIA $115 puts for (I’m guessing the open) $1.25, a $2,500 investment. If the Dow drops 5% ($6 on the DIA) we can assume the $115 puts will be worth (ignoring time value) approximately what the $120 puts are worth now – $2.20. Spending that $2,500 can net you a gain of $1,800 or more if the Dow continues to plunge.
Mattress number 2 comes in if we continue to fall. In this situation I would look to buy 10 more Aor $114 puts when they hit $1.10 and mattress number 3 would be 10 Apr $113 puts, when and if the Apr $113 puts hit the same $1.10. At each new level we should set a 20% trailing stop on the level(s) above it and, after 3 levels I prefer to roll out of the top position, take that basis off the table and put the profits into mattress number 4.
Just imagine that you are falling and falling and every 100 feet or so you figure it’s a good idea to buy another mattress.
We are not doing this to make money per se (although you can accidentally do well on these) but to protect the positions we have so we can afford to take our time reassessing them individually. If the market turns up (Hallelujah!) then a 5% up move will put (roughly) $2.500 back in your virtual portfolio while we can assume that the $2.500 worth of DIA Apr $115 puts we bought at $1.25 would slip to the value of the $110 puts (.55) leaving you with a loss there of $1,490 – the cost of your virtual portfolio insurance.
Of course this is just one example and you should consult your professional financial advisor to determine which index fund would work best for your individual mix of plays. I will be posting several more of these mattress plays for various indices up on the members site but you should seriously consider covering existing positions rather than taking on additional risk by trying to balance a heavily positive virtual portfolio by shorting or putting new stocks that have already dropped considerably.