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Tuesday, February 7, 2023

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

It's been a long time since we were worried about a steep drop.

We have some very successful hedges already as I've been pounding the table on TZA since $13.50 and, since you know I am a big fan of taking cash off the table in either direction, let's not be greedy and look at ways to "roll" our existing downside protection into new downside plays so we can set SENSIBLE stops on our now deep in the money short plays (very similar to our Mattress Strategy)

Keep in mind that Friday was the biggest market decline we've had since May, so adding a layer of protection here doubles our returns if this is the first leg of a major sell-off, or it gives us a smaller hedge that we can roll up later while we take our bigger hedges off the table.  As I have to say WAY too often to Members – It's not a profit until you cash it in! 

Hedging for disaster is a concept 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."  That "just in case" saved a lot of portfolios!  The idea is to take disaster hedges using 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 good 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 even just 5% of your virtual portfolio into that financial hedge would give you back 75% of your 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.  I have long wanted top put up a Buy List but it's still too risky as the Dow has been unable to break our 13,600 target and the S&P has failed to hold 1,440 and, as I warned just yesterday morning, ahead of a 200-point drop, the Dow has no real support all the way to 13,295.  As it turned out, we bottomed out at 13,312 and finished at 13,343.    

At this point, we are very likely in the capitulation/depression area of the curve BUT it is possible that we're only in FEAR and things are worse than we think.  I am HOPING (not a valid investing strategy), that Friday's high-volume sell-off was more capitulation by those who didn't realize Q3 earnings were going to be bad than the onset of fear as investors simply didn't understand how bad Q3 was.  Of course it was bad – why do you think the Fed moved to save the economy?  I haven't given up yet but we do need to be prepared for a larger breakdown – hence these trade ideas.

On the whole, we haven't been very bullish since the end of July, when the S&P topped out at 1,400.  We've kept our main, virtual Income Portfolio lightly invested as we keep expecting a drop and we haven't sold ANY short-term puts – specifically out of fear of being burned like this.  It's fine to speculate with our smaller portfolios but not with our main Income Producer.  One speculative play I did like on the release of QE3 was on gold on 9/23 – it's even cheaper now and makes a good long-term inflation hedge:

I'm not a big fan of gold (and we have some GLL short plays on it here) but, long-term, if it runs, it can be lucrative and, rather than buying 10 ounces of gold for $17,750, you can buy 10 GLD June $145/170 bull call spread for $16.70 ($16,700) and all GLD has to do is hold $170 (now $171.50) and you make $8,300 or about 50%.  Buying physical gold, it would have to move to $2,600 an ounce for you to get the same bang for your bullion bucks.  Break-even on that trade is $161.70 so it has built-in protection as well.  

Despite gold dropping $35 since I wrote up these trades, the GLD spread is still $16, so very little damage done there.  We also had a more complicated trade on silver that was anchored with the sale of 2015 puts on ABX, which has also dropped and now the 2015 $33 puts are $5.60 (were $5) and make for a great offset as long as you REALLY want to own ABX for net $27.40, which is 29% below the current price of $38.78.  As to the short-term GLL (ultra-short gold) hedge – we cashed those and, unless $1,720 fails to hold (the 50 dma), we don't think we'll need more.    

INDU WEEKLY I would urge you to read the original Disaster Hedge post in our Virtual Portfolio Section, 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 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 the top of the summer's range  for support, which were at the time:  Dow at 13,300, S&P 1,420, Nasdaq at 3,075 (blown thanks to AAPL), NYSE 8,100 and Russell 820.  These are all levels that give up all of September's gain but things can get far worse if we have another crisis of confidence, as we did in 2008-2009.  It's still too early to bargain hunt because that was a mistake we made in 2008 – looking for floors that never came – so we need to be judicious in our bottom-fishing expeditions.  

Keep in mind that these are 2nd stage hedges as we already have TZA hedges from higher levels (Russell 840-880, now 828) we have a Fed meeting next week and Fed speak could turn the market right back up but, we do need something, in case it doesn't.  That being the case, here’s a few ideas to help ride out a larger downturn as well as to protect our eventual buys:

  • DXD Jan $49 calls at $2, selling Jan $55 calls for $1.15.  This is a net .85 entry on a $6 spread so your upside is 605% at $55 (DXD is now $47.25).  If the Dow ends up holding 13,200 and moves back up, there’s a good chance you can kill this cover with a small loss as a $5 move on DXD is about 10% and that would be about a 5% move up in the Dow to 14,000 before the Jan $49s lose half their value (which is still more than you paid for the total spread).  You need $49.85 (+5%) to get your money back and that's a 2.5% drop in the Dow to 13,000, so you are well-protected for any dip below that line.  
  • TZA is still our favorite hedge and you can pick up the April $14/22 bull call spread for $2 and you can sell the April $13 puts for $1.35 for net .65 on the $8 spread, giving you 1,130% of upside potential and, best of all, with TZA at $15.60, you are starting out 246% in the money!  TZA drops $2.60, to $13 if the Russell goes up 6% plus these ultra-ETFs tend to decay over time but owning TZA for net $13.65 is not a bad portfolio hedge and the Russell would have to be net up in April for this to happen and, if so, your longs should be doing well.  

When you are entering a trade like this, assume you will have TZA put to you at $13.65 and allocate how much you are REALLY willing to own.  Say that’s $13,650, which would be 1,000 shares and that means you can make this trade with 10 contracts at a net cost of $650 plus (according to TOS) $4,500 in margin.  This play returns $2,600 if TZA simply stays flat and holds $15.60 through the April expiration.  This hedge then, protects $50,000 worth of existing positions against a 15% loss for $650 (hopefully, you already have buy/writes that protect you from a 20% drop, so we're good for 35% total downside)  plus some margin you'd better have laying around anyway!

  • SDS Jan $56 calls at $3, selling Jan $62 calls for $1.65 and selling HPQ Jan $14 puts for .87.  Here we are in a $6 spread for net .88 with the possibility of making $5.12 (581%) if SDS hits $62 (up $7.16 or 13% or down 7% on the S&P to 1,332).  We may have HPQ put to us for net $14.87 at that level (now $14.48).  Of course, we can roll the puts down to the 2014 $10s (now .90) – which is a pretty good entry on HPQ (30% off)!  Remember, the premise is that it's not likely to have HPQ go below $14, let alone $10 if the S&P is rising so your expected cost of insurance is that .87 – although you can stop the bull call spread out long before that happens.  If you are willing to own $15,000 worth of HPQ at around $10 in 2014, it's reasonable to take 15 of these hedges, which return $9,000 if the S&P falls 7%.  The margin on 15 short HPQ Jan $15 puts is just $1,500 according to TOS – so not tragic if forced into the long-term short puts.      

Another nice thing about this trade, in a vacuum, is that – IF we have a catastrophic failure that forces you to buy 1,500 shares of HPQ for $10 – there's a pretty good chance you will have collected that $9,000 from the SDS spread and that means you are buying 1,500 shares of HPQ for net $6,000 – just $4 per share!  

Another way to hedge SDS if you are not margin constrained is by selling SPY puts.  SPY Jan $125 puts are .92 so a net of .73 on the above spread and you KNOW the puts are rollable and, of course, the SPY puts CAN'T go in the money until AFTER you make $5.27 per spread.  What you are playing for here is that the S&P will drop 7% but not 12.5% (and, assuming a roll, 20%).  

I'm sure some of our more savvy traders have already realized that once SPY drops 10%, we can simply add more hedges and at 15%, more hedges and at 20%, even more hedges to protect against getting too burned on the short puts.  Layering in our Disaster Hedges is always a good plan.  After all, that's what these hedges are as we've already got plenty of hedges like this from when the market was 15% higher!  

The great thing about this kind of play is that, if the S&P goes up, the insurance is half price as the short puts expire worthless.  You can even stop out the $1.65 hedge at around $1 and you end up with something in your pocket as a reward for all your hard work.  

Keep in mind that this is insurance, not betting.  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 insurance is all you should need to offset reasonable dips in the market.  It doesn't mean you don't need stops.  

  • 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 $11.52, the Jan $12/16 bull call spread is just .60 with a $3.40 upside potential (566%).  You can reduce the net further by selling the Jan $9 puts for .35, dropping the spread to just .25 and increasing your potential gain on cash to 1,500%.  This is a very nice way to play against a breakdown in emerging markets.  
  • Finally, let's look at a stock play.  V has been a white whale for us, going up and up no matter how much we short them but, at $140 – they HAVE to be tired.  Earnings are on the 30th and they are expected to earn a solid $1.49 but, looking at tech and other sectors – it just doesn't seem like that much money is being spent.   AXP had in-line earnings and is down 5% since then and you can pick up the V Nov $135/130 bear puts spread for .85 and that makes up to $4.15 (488%) if V drops $10 (7%) but, we're looking for 500% trade ideas so how about selling an AXP April $45 (now $56.86) put for .66 and that knocks the spread down to .23 with a potential 2,073% upside.  

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 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 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 portfolio but, unfortunately, like Auto insurance, you just pay and pay and pay until you have that accident.  So safe driving!

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Those are some great hedge plays Phil.  Thanks!

Oh no!  Phil's puttin' up the Disaster Plays just when I was convincing myself that we weren't going to crash soon!  What to do?  The problem is, the charts look like Hell, even thought there are a lot of indicators suggesting we get new highs at least  into the elections.  After doing extensive analysis, I decided last Monday night that there was no need to panic, since several key factors in every major market downturn, at least for me, were not yet present.  The first being that I was experiencing no technology trauma (internet service down, major TOS platform migrations, etc), and the second being Phil's resolute optimism that QE3 would soon have an effect.  That was Monday night.  First thing Tuesday morning, my less-than-a-year-old Macbook Pro experienced a fatal "Kernel Panic" and wouldn't reboot.   No problem, I've learned to have backups for everything technology related.  And besides, I thought,  Phil's still not rolling out his Disaster Hedges…….
 Well, kidding aside, I just wanted to add to Phil's point about only buying the insurance you need, the key being to understand exactly how much insurance that is.   Since austerity has forced on me a discipline that good intentions never could, some time ago I instigated a regimen of making sure I used the TOS Analyser to individually determine the potential outcome of every single position I had under a variety of scenarios (including volatility increases and decreases).  Now, that's a lot of work, and since I don't like excess work, this regimen has really helped me limit my positions to those that are worth the effort of monitoring.  I find it's much easier to say goodbye to a position that's going nowhere if it's going to mean a lot more actual effort rather than just passively watching its value waste away.  Also, now that I understand my positions, I don't have to worry about open-ended risk, and I feel like I can take advantage of market opportunities, such as the ones likely to occur next week. Despite my superstitious crash anxieties,  I won't need to add any of these hedges unless we drop to my predetermined  "scale in" point where I will adding to my other positions.  In the past, my anxiety caused by not really knowing my risk would cause me to grab way too many of these hedges and then hold on to them too long, which really defeats their purpose.

General/Phil,
I feel I am totally out of my depth. After a year when I thought I was getting the hang of it, and saw myself doing reasonably well, the last few weeks — after losses in AAPL, VXX, and others, have left me in paralysis mode.
I am running two protfolios — an IRA and an actively traded portfolio.
In the IRA I've been doing long term plays taking the from the Long Term Portfolio (last years) playbook and some other good looking ones as they get discussed n the site, rolling and selling to get net costs down — so it's AA, ACI, AGNC, BAC, CEDC (don't ask- loser from way back), CHL, CSCO, F, FTR, GLW, HOV, NLY, SVU, WFR, WHR. So far with the exception of some Jan AAPL 690 calls which I bought to juice the portfolio a little, and which I've rolled into a 595/635 spread — thanks for the advice on that one — it's doing OK. Although it is down over 3% from where I started.
It's in the individual port that I've really been rocked, going from about $137K to $188K in September but now back down to about $93K. I have a few long term plays here BA, BTU, but I've mainly been using the $25KP plays, occasional MoMo and FAS Money. My biggest hit here was with some Oct AAPL calls which, as I mentioned before really knocked me down.
The danger ones left are 5 AAPL Jan 630/650 spread and of course the continuing 25K 10 Nov 635s covered over the weekend with Oct 26 625s.
I feel I've been working hard at this so I don't want to let what I've learned go to waste but do feel I'm doing something very wrong — oversized positions (yes on AAPL) overhedged (TZA, SCO and VXX) — and don't even know what advice I need to get back even to my starting point.
Obviously, all this may be moot if AAPL does well at earnings but I'm at the stage where I'm thinking why put money on hedges since the AAPL position is hedged in itself and the rest of what I have are long term plays.
Anyway, I would appreciate any help on this as I feel I've screwed it up pretty good. Can I rescue myself out of this mess with some patience? Or should I just throw in the towel before I did a deeper hold for myself. The paralysis is the worst problem as I'm not even thinking about any other plays now (even FAS) because of the AAPL situation.
TIA
 

 

Phil – like zipla, I too have lost quite a bit. More like 80% of the portfolio. I had 25 Oct 690 calls plus 10 Oct 685/695 spread which was an oversized position to begin with. I then rolled everything down to 40 Nov 670/690 BCS for a cost of 8.65 per spread, now 3. I do not have any money left to roll down and the only roll I see is to Jan 705/725. What wud you advise?

Does anyone have something(graphs) that shows that there has not been any wage inflation? Also, any graphs that show how costs have gone higher even without wage inflation?

Phil,
Trying to be proactive and anticipate rather than have to react I wanted to get some guidance on mgt of 2 GOOG positions: sht 6 –  jan/14 600 puts @ $31 and sht 3 – 550 puts @ $21 (now $45 and 32 respectively). Given that no one knows in an absolute sense whether GOOG has, in fact, seen its best days and may be overtaken by competition or changing events in its mkt space, I am slightly less bullish now than I was when I sld the puts 3 wks ago and less inclined (but not totally disinclined)  to own them long term at 600/550. I note that the last 2 days volume has been much heavier relatively in GOOG than AAPL – not sure if this portends a blow-off low or start of a waterfall decline. So given my current posture (guesses), what changes/rolls would you recommend.
Thanks in advance

Futures opening lower as the world was not saved over the weekend! Maybe buyers show up in Europe when we open at 3:00 AM!

The founder, chairman and co-CEO of NLY passed away yesterday:

Annaly Says Michael Farrell Dies After Cancer Diagnosed

Depth/Phil
I'm losing you a little on the latter part of the strategy — dealing with the short Oct 625s.
Get it that you put stops on at the appropriate points but when you say:
So, if AAPL doesn't make $625 by Thursday, … you need to roll anyway to whatever is $15 (??????)  but if AAPL goes up, you have the $70 spread that you paid about net $30 for  … and then you don't have any real trouble unless AAPL is over $685 on earnings and, even then,

And this is where I totally lost you:

the Jan $685s are currently $15 with a .27 delta so a $75 move up should put them to about the same price as the Jan $615s, which are $40 so really over $700 and you'll still be in decent shape. 

Sorry for being such a dunce. I'm guessing what we're talking about it a break-even play on the spread: That I have a chance of making $40 if the stock goes up so I can take that against the loss I might have to take if the Oct 625s go against me fast. Right????
To simplify: So I roll the 635s into the April spread at an extra cost of about $15. OK get that.
But the rest of it about manipulating the short 625 covers is a little mysterious. I can wait and see how the market is tomorrow and see how you deal with them — since you're got them in the 25KP as well. And I'm guessing one way or the other that's how we're going to deal with the anyway. Blow by blow as AAPL staggers or rises.
TIA

Hedging:  Phil, I just wanted to give you my feedback having been a PSW member since 2009.  I originally was intrigued by the ultra hedges using TZA, EDZ, and SDS as highlighted above. But after a couple years of using them, found that regardless of market direction, they almost always lost me money AND did not protect my portfolio during periods of declines or crashes. This was mostly due to timing as the spreads did not show much profit until near expiration. And during periods of market dislocation, the spreads are hard to roll, leg out of, etc.  And of course there is the ongoing ultra-decay.
 
So, what I have ended up using exclusively is basically full circle from your 2007 days, The Mattress Play.  I use SPY & SPX.  I keep it really simple. My longs are OTM 6-9 month puts. Then I sell weekly or front month covers, always slightly less in number than my longs. My portfolio payoff profile always has an UPWARD tail once a market crash gets out to a 10% or 20% decline.  This allows me to sleep at night. The tricky part is sizing relative to my portfolio. And it also allows me to do a momentum trade whenever I want by cutting / adding weekly or monthly covers when I need to get more or less bullish. Those options have lots of liquidity and I only need to worry about a single position to change my portfolio delta.
 
So, although I understand completely your hedging ideas, I see the constant questions, and the constant losses that many members are getting in TZA, EDZ, etc.  It seems many people end up over hedged. And ironically, I think your Mattress play is the solution for many members, although I know we haven't used it on this board for at least a year. Just something to think about.
 
For the rest of my portfolio, I do no $25K trading at all, and just focus on longer term stuff. At all times, I consistently do better when I have less positions in my portfolio, and when the positions I do have are longer term in nature. In other words, for both hedging and performance, SIMPLE AND PATIENT WINS. 

Phil,
Thks for the GOOG perspective, strategy and comments. My concern was based on the 6 sigma possibility that GOOG may have been overtaken by product market forces in the search space lost its privileged position and therefore its mojo. Would you consider selling weekly calls if GOOG stays in a sht trm dn trd?
TIA again

25k/ Phil et al.: The portfolios are great and I hope you keep them going in the style you have.  When I look at them I see several "layers" and I choose what fits my mood/ risk tolerance for the time frame. The aggressive layer (i will single that one out as recent market forces have shaken thing up) is important. When you are in a bind or feeling like you are a well rounded investor, trader, etc. needs to be able to move through it.  And seeing you navigate it I feel helps us tighten our OODA loops.

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