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Thursday, March 30, 2023


Hedging for Disaster – 5 Plays that Make 500% if the Market Falls

I think it’s time to revisit the concept of hedging for disaster, something I advocated during another "recovery," in October of 2008, where we made our cover plays to carry us through a worrisome holiday season and into Q1 earnings – "just in case."  The idea of disaster hedges high return ETFs that will give you 3-5x returns in a major downturn.  That way, 10% allocated of your virtual portfolio to protection can turn into 30-50% on a dip, giving you some much-needed cash right when there is a buying opportunity

At the time, I advocated SKF Jan $100s at $19.  SKF hit $300 around Thanksgiving and those calls made a profit of over $280 (1,400%), so putting just 5% of your virtual portfolio into that financial hedge would give you back 75% of your virtual portfolio when you cash out.  Keep in mind these are INSURANCE plays – you expect to LOSE, not win but if you need to ride out a lot of bullish positions through an uncertain period, this is a pretty good way to go.  We cashed out last week but not everything, we had 15 positions that weren’t worth closing out from our Buy List, which is not too surprising as 64 of the 66 plays were winners so of course we had a few that weren’t done yet!

Seven banks were done on Friday and were seized by the FDIC – the most in one week since October, including Advanta Bank of Draper, Utah with $1.6Bn in assets and the FDIC could find NO ONE to take over their operations and took a hit of $636M on that bank alone.  Think about that for a moment – here is a banks that is supposed to have $1.6Bn in assets but, when the government finally has to step in – it turns out they are $600M short (40%).  Gosh I hope our entire banking system isn’t 40% short – don’t you?

Maybe it’s just and extreme example.   Three of Friday night’s bank failures are in Georgia: Century Security Bank of Duluth. Appalachian Community Bank of Elijay, and Bank of Hiawassee.  They had respective assets: $96.5M, $1.01B and $377.8M and ALL are being acquired at a cost to the Deposit Insurance Fund of $586.9M.  Ooops, that’s 40% too.  Maybe there’s a pattern here and the FDIC steps in when banks are going past that 40% threshold.  That’s good news because we can assume C, with their $2Tn in reported assets probably REALLY has $1.2Tn so yay, I guess…

Are we at the above point of "maximum financial risk" or are we only just now getting optimistic (after a 70% market rally)?  12 out of 13 analysts surveyed at top investment banks are projecting the market to close higher in 2010.  How much higher?  An average estimate of 1,250 for the S&P, up about 7.5% from where we are today.  DB’s Binky Chada is the most enthusiastic, predicting 1,325 while CS’s Andrew Garthwaite is on the low end at 1,125 with GS (Kostin) at 1,250 and JPM (Lee) at 1,300 so, on the whole, it’s a very, very bullish crowd but that makes this a very, very cheap time to buy downside protection – because there’s no demand for it!

I would urge you to read the original Disaster Hedge post to get an idea of our mindset at the time, where I said:

As far as hedging goes, if you are 50% invested and 50% in cash and you are worried about losing 20% on the stock side in a major sell-off, then the logic of these hedges is to take 40% of your cash (20% of your total) and put it on something that may double while the other positions lose.  If things go down, your gains on the hedge offset some of the losses on your longer positions.  If things go up, you can stop out with a 25% loss, which will "only" be a 5% hit on your total virtual portfolio but it means we are breaking through resistance and your upside bets are safe and doing well.  That is not a bad trade-off for insurance in this crazy market.  Also, be aware that these are thinly traded contracts with wide bid/ask spreads and you need to use caution establishing and exiting positions.

As we are now, we were very keyed on watching our levels, which were at the time:  Dow 10,650, S&P 1,135, Nasdaq 2,000, NYSE 7,400 and Russell 700 – all marks we are revising 18 months later with the Dow at 10,741, S&P 1,159, Nasdaq at 2,374, NYSE 7,386 and Russell 673.  It’s interesting how the broader indexes are trailing but clearly the Nasdaq has made good progress compared to the others – up almost 20% in 18 months. 

We had a very happy Thanksgiving in 2008 BECAUSE we were prepared for a nice correction and I want people to be able to enjoy Spring and Summer 2010 the same way so that is the goal of our new protectors.  Here’s a few ideas I have to ride out a possible downturn into the summer months:

  • DXD July $25 calls at $3.10, selling July $29 calls for $1.60 and selling July $25 puts for $1.05.  This is a net .45 entry on a $4 spread so your upside is 788% at $29 (DXD is now $27 so you are 344% in the money to start!).  I like this play because you are starting out $3 in the money on your spread.  If the Dow breaks over 11,000 and holds it, there’s a good chance you can kill this cover with a small loss as a $3 move on DXD is 10% and that would be about a 5% move up in the Dow to 11,250 before the put you sold becomes a problem.  Under 11,000 you stand an excellent chance of at least getting your money back, which makes this very cheap insurance! 
  • FAZ Oct $11 calls at $4.20, selling Oct $17 calls for $2.25 and selling Oct $11 puts for $1.10 puts for net .85 on the $6 spread (600% upside at $17).  This one is risky as you can end up owning FAZ for net $11.84 but it’s currently trading at $14.17 so that’s a 16% discount off the current price (a 5% rise in financials) and FAZ is always a good hedge against your financial longs. 

When you are entering a trade like this, assume you will have FAZ put to you at $11.85 and allocate how much you are willing to own.  Say that’s $12,000, which would be 1,000 shares and that means you can make this trade with 10 contracts at a net outlay of $850 in cash plus (according to TOS) $2,200 in margin.  This play returns $6,000 if FAZ goes up 25% (8% drop in the financials) and holds $17 through Oct expiration.  On the risk side, imagine FAZ falls 50% to $7 then you are assigned at $11.85 and have a $4.85 loss x 1,000 shares = $4,850.  If that represents 10% of your virtual portfolio and you are fairly confident that your bullish financials will make at least $1,000 a month if the Financials finish flat to higher for the next 7 months – then this is a very cheap hedge

  • SDS Sept $30 calls at $4.20, selling Sept $37 calls for $2.20 and selling Sept $27 puts for $1.10.  Here we are in a $7 spread for net .90 with the possibility of making $6.10 (670%) if SDS hits $37 (up $5.50 or 17% or down about 8.5% on the S&P to 1,050) and we have the ETF put to us at net $27.90 if the S&P rises 7% and hits the target of our 12 out of 13 analysts.  Of course, we can roll the puts down to 2012 and spend another $2 after losing the .90 this year which would make the net cost of a similar spread for 2012 $2.90 with, perhaps, 100% upside if the S&P doesn’t climb another 10% so figure your "insurance cost,"  unless the S&P really runs away, is about .25 per month to buy $7 of protection.  Keep in mind though that these are time-targeted speads so you don’t make $7 unless we pretty much get all the way to September expiration on target.  

One way around that is to simply buy a long call, like the Sept $29s for $4.60 and selling the Jan $31 puts for $4.30.  That puts you in the $29 for net .30 with SDS currently at $31.58 so you capture every penny of an upward move.  In fact, you upside delta is the .68 from the $29 calls plus .40 from the Oct puts so you make $1.08 for every $1 SDS goes up, all off a .30 outlay!  Of course the downside here is harsh so this play is simply about your faith in the rolling process as the SDS heads higher.  The bottom line is you spent .30 and you owe a Jan $31 putter $4.30 so you are in for net $4.60.  There are no longer puts on SDS yet but looking at the April $36 puts, which are $4.60 and seeing that’s a near-even roll to the Jan $31 puts – we can figure we have about $6 worth of leeway into 2012, which is about 20%, which is about a 10% upward move in the S&P so we start to get really in trouble here at S&P 1,275. 

Is it worth the additional risk?   If you look at it more like a play you’ll set a $1 stop-loss on, then I think so but not to ride it out to the very bitter end.  Let’s take a close look at a more hedged way to play an overall strategy using the Russell:

TZA is a favorite play at PSW and there’s nothing I like more than a good ultra that’s been beaten to death.  Poor TZA was at $114 just 12 months ago and a 100% move up in the Russell has crushed it by 93%.  That is FANTASTIC news for us as new investors because, all we can to lose betting the RUT won’t climb another 100% is about $6.50, but if the Russell falls "just" 50% TZA can jump 150% to $18.75 so let’s see how to play that.  For starters – I like the fact that a putter will pay you $1.10 betting that the RUT will finish at $3.90 or lower on Jan 2012.  That’s down 50% from here implying a 17% gain in the Russell to 787, right back near the all-time highs.  So let’s start by taking that man’s $1.10:

  • Leg #1 is collecting $1,100 for 10 TZA 2012 $5 put contracts = Credit $1,100, net margin (non PM) $570.  Danger is Russell rising more than 17% (787) and having TZA put to you at $5.

Now TNA is the opposite number so if TZA is going to fall 50% then TNA would go up 50% to $75+.  I can play TNA to finish at $75 or even $55 by playing the 2012 $50/55 bull call spread at $1.80, which will pay me $3.20 in profit if TNA is 4% higher than it is now.  So there is NO possible way that I can owe my TZA 2012 $5 putter a penny without collecting $3.20 on my TNA calls.  If I just want to cover my risk of being assigned 1,000 shares of TZA at net $3.90, I can pretty much offset that by buying 10 of these at $1,800.  You can stop right there if you want to be bullish as you’ve now spent net $700 for a $5,000 upside if TNA rises at all and your "worst case" is that TNA rises more than you thought and you can possibly end up having 1,000 shares of TZA put to you at $5, which would effectively be 1,000 shares of TZA at net $700 (now $7,500) so anything over .70 a share (which is another 100% gain on the RUT) is profit

If, however, the Russell falls, then TZA goes down and you paid net $700 and get nothing.  That’s why that’s a bullish play even though your bullish prize is owning 1,000 shares of TZA for $700 (strange isn’t it?).  We can fix that by making another supposition.  The TNA 2012 $20 put is $4.10 and $20 is 60% down from here so the Russell would have to fall about 20% over the next 2 years, back down to 540 for those to go in the money.  Let’s say we’re bearish but not THAT bearish and we sell 5 of the TNA 2012 $20 puts at $4.10 to collect $2,050.

  • Leg #2 is spending $1,800 on 10 TNA 2012 $50/55 bull call spreads at $1.80.  Debit $1,800, no margin.  Net Debit $700.  Danger is a 2% or more fall in the Russell, expiring this spread worthless.
  • Leg #3 is collecting $2,050 on 5 TNA 2012 $20 puts at $4.10.  Credit $2,050, net margin $1,100 (non PM).  Net Credit $1,450, net margin $2,200.  Danger is the Russell falling below 540, forcing you to own 500 shares of TNA at $20 (now $53.23).

Now we have $1,450 burning a hole in our pocket and we have a range on the Russell between 540 and 787 that will make us happy.  Now let’s add a little real disaster protection to offset that potential loss for a downside move below 540 and that is very easy because the TZA 2012 $5/12 bull call spread is just $1.70 so 10 of those pays up to $7,000 if the Russell is down 20% by Jan 2012 and pays quite a bit at points in-between as well.  Keep in mind that if the Russell DOESN’T fall at least 20% by Jan 2012 – we keep the $2,050 from our $20 putters and we will still be ahead $350 overall UNLESS the Russell rises so high that our $700 purchase of the TZA ETF is wiped out and then we’ll down $350 (but owning 1,000 shares of TZA as a consolation prize). 

  • Leg #4 is spending $1,700 on 10 TZA 2012 $5/14 bull call spreads at $1.70.  Debit $1,700, no margin.  Total net debit = $250, total net margin = $2,200.  Danger is an upward move up in the Russell of more than 10% expiring spread worthless.

What is our "best case" scenario here.  If the Russell falls about 20%, which will boost TZA by 60% to $12 and pays us $7,000 on our net $250 investment (2,700%) without triggering the TNA puts.  If the TNA puts do trigger in a massive disaster we will own 500 of the TNA ETF at net $3,000 (now $26,500), which is not a bad way to take up a bullish position at a new market bottom.  Because our TZAs are already $2.50 ($2,500) in the money, any move down between here and 540 into Jan 2012 should be nice and profitable.  Of course, this is all very adjustable and we can take advantage of move up and down along the way – I just thought it was a good way to illustrate how you can hedge both sides of the fence for long-term protection where even the "black swan" scenarios aren’t so awful

Of course keep in mind that this is insurance, not betting.  Betting is the call/put combo on SDS, which is a bearish bet on the S&P that has an immeditae payoff on any downward move with an unlimited upside.  These are hedges that are meant to perform for you if your upside bets don’t work out and will hopefully not cost you too much money when your upside plays go well.  If your upside plays are sensibly hedged, like our buy/writes that pay at least 10% a quarter in a flat to up market, then this kind of sensible insuarance is all you should need to offset reasonable dips in the market.  It doesn’t mean you don’t need stops.

Now let’s finish up with a specific disaster hedges on the things we are worried about.  As a hedge against inflation, some people like gold.  I am not a fan of gold as I think it’s overpriced but it does have it’s uses and I wrote a post on hedging into gold back in March of last year so maybe it’s time for an update.   As a hedge against many other things, including inflation, I prefer TBT.  If there is inflation, then the cost of lending and borrowing money will rise as the lender knows that they will get paid back in dollars that are worth less (worthless?). 

This is why I don’t buy into a commodity rally when the cost of capital is low – clearly the lenders don’t believe rising costs are a long-term factor if they will give you money for 30 years at 5%.  Land is a commodity.  Copper and wood and even the labor that goes into building your home is a commodity so if gold is a true "hedge" against inflation and gold is up 50% in two years – then we should expect similar appreciation from a home and the banks that are lending Trillions of Dollars at a mere 5% are fools.  Maybe they are – maybe gold is a little ahead of itself… 

  • TBT is a simple bet, we don’t think rates will go lower.  Over the past 15 months rates have stayed down around 0-0.25% on the Fed and TBT has gone from a low of $42.24 to a high of $59.75 but, on the whole, has gone nowhere at all in 15 months.  That would suit us just fine if we sell the 2012 $40 puts for $3.50 with $4 in net margin for our troubles.  With $3.50 in hand there is no need to be greedy so we can buy the 2012 $50/70 bull call spread for $3.75 and we’re in the $20 spread for .25 with a lovely 7,900% of upside potential if rates run away.  $500 buys 20 of these spreads and your downside follow-through is to roll the puts to 2x longer $30 or maybe $20 puts but that $500 returns $40,000 real dollars if rates move up 25% over 2 years – figure to about 6.5% for a 30-year.  If you have an adjustable loan and want to hedge it, this is a nice way to do it. 
  • EDZ is my other universal hedge.  It’s a 3x inverse to the MSCI Emerging Markets Index which is BRIC-weighted but also includes Africa, Eastern Europe, the Middle East and Latin America so our bet is that something goes wrong somewhere in the world sometime.  With EDZ now at $46, the 2012 $70 calls are very overpriced at $16, especially since you can buy the 2012 $45s for $19.  Even paying $4 for this spread is not at all terrible and you can JUST do that and sit on your $35 upside (775%) from a spread that’s currently at the money or you can drop your net down to $1.50 by selling 1/6x the 2012 $40 puts at $15.  I like this play because you are collecting $1,500 against $395 in net margin and buying $15,000 worth of upside protection for $2,400.  Should EDZ spike up, you can even pick up a little cash selling front-month calls so a fun, flexible way to sleep well on the weekends and not worry about international mayhem.

As with all of our protection plays, if we become more confident that the market will NOT collapse, then we simply take them off the table with a small loss and that makes us more bullish but having a few hedges like this in your virtual portfolio can do a lot to cushion the blows from any major market sell-offs. 

I cannot remind you enough though that these are insurance plays and they are not ideal for rolling or adjusting and you should EXPECT to lose money if the market heads higher – much the same as you expect to have "wasted" your life insurance premium for the prior year every time you celebrate another birthday….

As with life insurance, it may make you feel good to walk around with $50M worth of protection in case you get hit by a bus but – is it realistic?  Look at your virtual portfolio and think about what kind of protection you REALLY need.  If you have $100,000 worth of May buy/writes that are good for a roughly 15% dip in the market, then you don’t really need ANY protection against a 15% drop.  If the market drops 25%, then you will lose 10% on what you have now.  If the market drops 40%, then you lose 25%.  We all learned how valuable it can be to simply stay even in a major market drop as opportunities abound then so simply putting 5% away on hedges that will pay 25% back when the market drops 40% will let you cash out with 100% of what you have now and go shopping – that’s all insurance needs to do.

Disaster hedges are a good exercise in managing your portflio but, unfortunatley, like Auto insurance, you just pay and pay and pay until you have that accident.  So safe driving!



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Phil,  hope you are having a nice Sunday. Beautiful 60 degrees and sunny here in Colorado Springs. Appreciate all the fine work you are putting into the hedges. Your computer might have hiccupped b/c there are several bullet marks with nothing behind them….
"black swan" scenarios aren’t so awful

Apr $11 calls at $1.  This is a bet that the commodity bubble will collapse or the economy will slow and the materials sector will sell off.  SMN was $82 last November (coming off $15 in June) so figure they can go up about 5x on a good run.  Currently at $9.37, that gives us a max expected upside (in a disaster) of about $45 and, of course, we’d be thrilled to see half of it at $27, which would be a $1,600% pay-off on this play.

Thanks again.

Phil- got it. By the way, when you go through your thought processes on what I consider to be somewhat complex trades, it’s very helpful. Understanding how a successful, professional trader THINKS is very valuable. During the week I know you don’t have time to go through it like that.

Phil – on the TBT play, you mean "buy" the TBT 2012 $50/$70 bull call spread?
so we can sell the 2012 $50/70 bull call spread for $3.75 and we’re in the $20 spread for .25 with a lovely 7,900% of upside potential if rates run away. 

Phil question about your TNA/TZA play: you choose Jan12 options, is it mean you plan to hold them for long time? what you reccommend to do if lets say market get 10% correction in couple of weeks? take profit and run or just stick to it as a Black swan protection?
I found it is a hardest part of protection plays, we don’t know how deep correction will be

Your hedges are great in design–on the first one, the DXD; did you mean to buy or sell the july 25 calls at 3.10?  
Thank you again,

new guy here.
great constructs. amazing. this is why I subscribed.

iprosper20 – Phil means to buy the DXD JUL 25 calls, because this is a disaster hedge your bet would be for DXD to go up so you would buy ITM calls.  However, Phil has a math flaw when he says "net .40 entry" because buying calls at 3.10 and selling puts and calls for 1.80 is net 1.30 as I see it.  Still his math is correct that you make almost 400% at DXD = $32+.

I, too, appreciate that you take the time to go through the process here on the weekend. There is a lot of information here and it helps this newbie if you can specify as much as possible.
Thank you for your excellent work!

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