Warren Buffett’s Rule #1 of investing is: “Don’t lose money” and the integral part of succeeding at Rule #1 is hedging one’s virtual portfolio. The question then is: “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 favorite 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 raised concerns over the pending $2Tn Deficit that is predicted that the energy sector would take us down this week (it did) even while calling a bottom on oil at $35 and looking to pick up stocks on our Buy List on the way down. Obviously the market itself is all over the place and, while we may guess well, we simply can't be sure of the direction.
The VIX is a testimony to this, finishing the day at 46.11, still historically way above average and indicating tremendous amounts of market uncertainty. And we got the drop we were looking for this week and Phil extolled people to buy off THE LIST during both Wednesday and Thursday's very scary sessions. 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 (or certainly should be!), we have much less fear of the market no matter which way it moves. Obviously after such a significant market downturn, fear is paramount, uncertainty is at a peak and hedging should be a trader’s top priority because as Phil once 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 an old KMP trade in another educational post). 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 often has used DIA puts and calls for this purpose in the past but lately, the market has been too volatile for this strategy.
One play Phil does like as an example is WMT (currently at $51.56), which is likely to stay between $40 and $60 for the next 2 months:
Buying WMT Jan 10 $40s for $14.47 AND Jan 10 $60 puts $12.77 (total cost $27.24)
Selling WMT Mar $50s for $4 AND Mar $50 puts for $2.59 (total income $6.59)
Effectively the bet is biased neutral that this stock will finish between $43.41 and $56.59 by March 20th. As long as the stock does not move more than $6.59 past the strike (up or down 12.8%) we will make some profit on the March puts and calls. No matter what price WMT finishes at, our 2010 put and call combination will still be worth net $20 so just $7.24 (our premium) is at risk. Once we collect that $7.24 (.66 per month), all other premium sale is profit. Should we collect the entire March $6.59 (unlikely) at $50, we will have made 91% on our capital at risk back by selling 2 of the 11 months (18%) worth of premium we control.
So, in just 2 months we take in approximately 91% of the value at risk of our long options and benefit from the higher time decay in the shorter-term options. This process can be repeated all the way through to January 2010, where we will have almost surely paid off the cost of the long option premium through short call premiums.
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 October with SKF). While not as profit optimal as straight covered leap positions, where Phil makes 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. Phil likes to take short profits from these trades and invest them in widening the long spread (opportunistically rolling each leg into better position), lowering the premium and increasing the strike zone as a way of "banking" the profits.
Other strategies such as bull puts, bear calls, bull calls, bear puts, straddles, strangles (see Peter's excellent article on the subject) 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
