Merry Christmas!
I hope you get everything you want this holiday season and, most importantly, I hope you have time to spend with your family. I love waiting for my kids to wake up on Christmas morning to come out of their rooms so I can videotape (gosh I’m old, there’s no tape anymore) them in those first moments of Christmas morning – how can I not be of good cheer anticipating that?
I have something I can give you for the holidays as well. Not peace on Earth but perhaps peace of mind heading into the New Year – a way to help insure some future prosperity with a few inflation-fighting stock picks that can brighten up your portfolio, which also can be used to help balance your home's budget against unexpected cost increases.
This isn’t an options seminar or one about risk or leverage – these are just a few practical ideas you can use to hedge against inflation as it may affect your everyday life using basic industry ETFs and some simple hedging strategies to give you an opportunity to stay ahead of the markets if they keep going higher.
We haven't felt the need for inflation hedges since 2011 as the Fed has kept us in a somewhat DEflationary cycle but our 2011 hedges were good for 300-600% returns and we're simply going to repeat the same, simple concepts here to set up good, rational hedges against inflation to insure a financially healthy and happy 2016:
Idea #1 – Hedging for Home Price Inflation
Let’s say you have $40,000 put aside for a deposit on a home but you’re not sure it’s the right time to buy. On the other hand, let’s say you are worried that home prices will take off again (I doubt this but you never know). XHB is the homebuilder’s ETF, currently at $34.49 and they bottomed out at $31.62 in August and still well off the highs for the year of $39 right before the flash crash.
You can sell 20 contracts of the XHB 2018 $28 puts for $2.25 each ($4,500) and that obligates you to buy 2,000 shares of XHB at $28 (16% off the current price) and you can use that money to buy 20 2017 $28/33 bull call spreads for $3.50 ($7,000) and that's net $2,500 out of pocket and you have 20 $5 contracts that pay back $10,000 if XHB simply stays flat through 2016. These bull call spreads, however, do not pay off early – the ETF needs to be above $33 at Jan 2017 options expiration day (the 20th).
So you are putting up $2,500 in cash and the margin requirement on the sale will be roughly $5,600 in an ordinary margin account. What have we accomplished? Well, if XHB goes up, your $2,500 becomes $10,000, adding $7,500 (300% gain on cash) to your $40,000 deposit, that should keep you up with up to a 20% jump in home prices but, if they go up that fast, getting a deposit will be the least of your problems!
On the risk side. We certainly don’t expect XHB to go to zero but let’s say it falls to $20 (1/3). Well, you are obligated to own 2,000 shares at $28 ($56,000) and you would have lost $8 per share, so $16,000 is your risk there but I would put it to you that, if we have a crash of that magnitude again, you are better off losing that $16,000 than if you had bought a home for $400,000 and had it drop 20% on you ($80,000) or even 10% ($40,000) and again, that’s a very extreme example and you are not locked into the trade, you can get out when the loss is $5,000, for example, keeping 87.5% of your deposit and feeling good about your decision to wait out an uncertain housing market.
That’s what hedging is, it gives you a cushion that can prevent things from getting away from you. For example, you can hedge this hedge by buying 20 2017 $28 puts for $1.20 ($2,400) and you cap your downside at $12 (the $16,000 loss) but you raise your outlay to $4,900 and lower your reward potential to a still respectable $5,100 (104%) – just an example of a way to control the downside and you can trigger a cover like that only if XHB fails to hold, for example $25. You can actually work these swings to your advantage by adjusting the trade as the stock moves through a channel but, for the sake of simplicity – we’re just discussing passive risk management examples. The idea is to reduce your risk of waiting – that lets you sit back and make an intelligent, well-timed decision without worrying that the market is getting away from you. Unlike CDs or Bonds, there is no penalty for an early withdrawal from a hedge, other than the bid/ask spread you may pay if you do it very quickly.
Idea #2 – Hedging for Fuel Inflation
Gasoline prices have dropped drastically this year and, if you are the average family, you buy about 1,000 gallons of gas per year ($2,000) and spend another $1,500 heating your home. That’s $3,500 a year spent on energy and it’s already down over $1,000 from last year – we might want to lock that in!
XLE is the ETF for the energy market and it’s currently trading at $61.57. If you want to guard against a $1,500 increase in the price of fuel next year, you can, very simply buy 3 Jan 2017 $60/65 bull call spreads for $2.35 ($705) and offset that cost with the sale of 2 2018 $40 puts for $2.50 ($500) for a total cash outlay of $205. If XLE simply hits $65 (up 5%) into Jan of next year, you make $1,295 (631% on the cash).
We can assume any increase in fuel prices over the year will push them higher and XLE has pretty much held $60 since 2010, the last time oil was below $50 that August, so this is a very nice mechanism for hedging 20% of your fuel cost. What’s nice about this is oil can fall and you’ll save money on your fuel and, as long as XLE doesn’t fall more than 35% by 2018 – the trade only costs your $220 cash outlay and you should save far more than that on lower energy prices (assuming that relationship is maintained, of course). Below 35%, you get assigned 200 shares of XLE at $40 in 2018 and that’s a price that’s held up very well since 2005, when oil was under $40. So a risk of owning $8,000 worth of the Energy Spider, which puts you bullish on oil at $40 – which will always make a another nice long-term general hedge against inflation.
Now our Members at Phil’s Stock World know they can roll those puts or convert those put assignments into buy/writes or do a dozen other things to mitigate the losses – as I said, these are really basic examples of how anyone can hedge their real-life budgets to help them make long-range plans to fight inflation.
Idea #3 – Hedging for Food Inflation
If you think you spend a lot on fuel, maybe you haven’t been to the grocery store lately. I knew food inflation was getting out of hand when the A&P’s fruit and vegetable prices started catching up with Whole Foods. I used to get a few cool items at Whole Foods and stop at A&P for the staples but there’s barely a difference in fruits and vegetables anymore when it used to be extreme. Good for Whole Foods and local growers but not so good for the average consumer who is being bled dry by commodity speculators and agriculture cartels.
And the middle-men are getting crushed too. A&P (GAP) went bankrupt and DF has flatlined with WFM down for the year, even after a spectacular pop in December. Perhaps the CEO's of Dean Foods and Whole Foods can benefit from this hedging exercise as well.
DBA is the way to go here. It's been a while since we've liked them when they shot up early in 2014 from $24 to $29 and, since then, it's been straight downhill back to $20.48, where we love them on the long side again.
If you spend $10,000 a year on groceries you can risk being assigned 400 shares for $8,000 and sell 4 of the 2018 $20 puts for $1.25 each ($500). That money can be used to buy 8 of the 2017 $20/23 bull call spreads for $1.15 ($920) and that’s net $420 out of pocket (2 week’s shopping) and the upside, if DBA simply hits $23 (up 7%) is $2,400 less the $420 laid out is $1,980, so a 20% hedge against food inflation and your risk is owning 400 shares of DBA at $20 ($8,000) as a long-term hedge – only if food prices continue to go lower.
The 2018 put sale, if DBA should go to $16 (down 20%), would cost you $1,600 – less than you will probably save on food. Remember, these are not magic beans that pay off no matter what the market does – these are hedges against inflation and, if there is no inflation, then you will save LESS than you otherwise would have but, again – there are dozens of ways to make owning DBA long-term a successful part of your portfolio. Instead of randomly investing your retirement savings – trade ideas like these are ways to put some of the money to work for you – in ways that can help you manage your bills NOW – as part of your daily life.
Inflation Hedge #4 – Hedging Against Rises in PSW Member Fees
We run a unique service. I am on-line most trading days chatting live with members about trades like this. Optrader, Trend Trader, Sabrient and several of our other writers are on-line as well but there is a limit to how many people we can effectively get back to in a day so we limit our Membership and, when it gets too crowded, we raise our prices (we just did last year, in fact). We hadn’t raised them in a while but that summer we had to as we were going over 300 comments a day in my chat, which is around my limit. Unfortunately, that made the service a little expensive for some people who wanted to join up.
So, for 2016, let’s make things interesting with my favorite hedge. If you sign up for a full-year membership between now (12/25/2015) and Jan 2nd, 2016 and the following trade idea does NOT net 100% on the cash outlay by expiration day on Jan 2017 then I will give you a free Membership for 2017! That’s a 50% discount on two years and your hedge can be going for let’s say $2,500 (1/2 the Basic Membership) on the spread and you either make $2,500 which is 1/2 of the 2015 Membership or you get 2016 for free, which, assuming you lose all $2,500, is 50% off 2015. No matter what, you get one year of a PSW Membership for 1/2 price. Not bad right? You do not have to buy the spread to play – just the Membership, which is non-refundable so don’t get cute!
(Probably good time to put in some kind of contest disclaimer that this is just for fun and we guarantee nothing at all and that we can change the rules at any time and that we accept no responsibility for anything under any circumstances whatsoever and that billions may play and nobody might win – how’s that? You just have to trust us, we’re not in the contest/guarantee business – I just want you to know how good I feel about this trade idea. Always consult a professional investment advisor (I’m not one) before doing anything!)
Anyway, what’s the trade? VERY simple on NATURAL GAS! I just wrote a post on why I love UNG down here (was $7 at the time, already $7.69) and UNG Jan 2017 $5/9 bull call spreads for $2 can be offset with the sale of Jan 2018 $7 puts for $1.60. That will be net .40 on the $4 spread (we are not counting the margin amount, which is about $1 per short contract, just the 0.40 cash outlay) and the payout if ABX reaches expiration at $9 (now $7.69) is $4 – or 900% more than the 0.40 outlay.
To make 100% on the cash (0.40), the net price of that spread has to be .80 or greater – that’s the "bet." Obviously, if the spread is even a penny over $7, the $7 puts would expire worthless and will not be an issue and, at $7, the spread returns $2,000 for each $400 invested (10 contracts). Remember, if it fails to return at least 100% and you have signed up for an Annual Membership in the next 7 days – you will get a free year in 2017.
Now, if you are thinking, after going over these ideas and seeing how a few of our old trades worked out: "Well, that’s too easy, there’s a very good chance of making 100% on that trade." Well, that’s kind of my point! Don’t you think you should learn how to trade like that? This is the whole point to using options and hedging in a balanced virtual portfolio and that is what we teach over at Phil’s Stock World every day.
I very much hope all these trades work out well, ESPECIALLY the last one!
Have a very happy holidays and we hope to see you inside in the new year.
All the best,
– Phil
