The Tycoon Report

The Way to Save Your Portfolio from a Sell-off

Monday, October 19, 2009 | Ron Ianieri

Last week, we spoke about what we would do to protect ourselves in this market environment from a potential sell-off.

A 'Dynamic' Downside Approach

We spoke about dynamically hedging our portfolio by purchasing puts in an Exchange-Traded Fund such as the Dow Diamonds (Symbol: DIA), the S&P 500 SPDR (Symbold: SPY), or the Nasdaq-100 Trust (Symbol: QQQQ, also called "the Qs.")

We also said that if our portfolio has just a few stocks in it, we could buy puts in those individual stocks to protect them individually instead of protecting the portfolio as a whole.

Regardless of how you protect your positions (i.e., the whole portfolio at once, or stock-by-stock), you need to know what to do with the protected position in case the expected downside movement does occur.

I have received many e-mails asking about what to do concerning “the next move” … what it is and how it would work.

So Stocks Go Down. Then What?

So many of us, particularly those of you who are newer to the "options scene," don’t really understand how these protective puts can function in this scenario.

Many of you lack experience in this type of strategy, so I think it is best to go through the mechanism of this “protective put strategy” to be better prepared for the next big sell-off.

Let’s start out with a simple example.

Say we own 500 shares of XYZ Corp. that we bought at $100 per share. To hedge against a possible downside move, we decide to buy five contracts (remember, each contract controls 100 shares of stock) of the January $95-strike put options for $2 per share ($200 per contract) to protect our stock position.

The purchase of the puts would cost us a total of $1,000 (five contracts x 100 shares per contract x $2).

Our ownership of the XYZ Jan 95 Puts gives us the right, but not the obligation, to sell XYZ Corp. at $95 per share at any time between now and January expiration. 

If the stock sells off hard between now and January expiration, we have the right to sell it to someone else at $95, no matter how low the stock goes.

Protective Puts Take You Out of Limbo

So, if we wake up one morning and the stock opens down $60 (at $40), we have the right to sell it at $95 to someone else.

If we did not own the put, we would have a $60 loss even if we had a stop-loss order on our shares for protection.

With the puts in place, our loss is significantly less than it would be without the puts. Instead of the $60 loss if we simply owned the stock without protection, we would only have lost $7.

This maximum loss comes from two things:

• The first is the loss from buying the stock at $100 and then selling the stock out at $95 ($100 - $95 = $5 loss) through the puts.
   
• The second part of the loss is the $2 spent on the puts ... the cost of your insurance.

So now, with the stock at $40, you have a $7 loss and no stock position, as you would have sold the stock to someone else by exercising your puts.

But, you now have no position ... and that may not be optimal!

Pullbacks Can Provide Opportunities

You see, depending on the stock, $40 may be a terrific buying opportunity.

We have just seen tons of examples of this over the last year. Goldman Sachs (Symbol: GS) down under $50 per share and Apple (Symbol: AAPL) down below $95 per share are just a couple of many, many examples. 

The puts' ability to keep our losses controlled and limited is extremely important.

But there is another way to get what we want in this scenario. We can have our loss limited to $7 and still keep our stock!

How?

Do NOT exercise your put! Instead, trade out of it!

When 'Not Exercising' Can Be Healthy...

The way the put actually works is to gain value in and of itself as the stock loses value. So, the put's increase in price offsets the stock's decrease in price.

With the stock at $40, the stock has lost $60. However, the Jan 95 Put will now be worth $55 ... gaining $53, since the stock traded down from $100.

The $53 profit in the puts largely offsets the $60 loss in the stock. Combined, we are left with a loss of only $7 instead of a possible $60. 

Some of you might want to know why the $95-strike put will now be worth $55 now with the stock at $40.

Remember, the put gives you the right to sell XYZ Corp. at $95 per share. With the stock at $40, our right to sell the stock at $95 is worth $55 because the stock could now be purchased in the open market for $40.

Sell High, Buy Low!

Selling at $95 through the puts, and buying at $40 in the open market, would create a $55 profit. Therefore, the right to sell that the put gives us is worth $55 and, thus, the put is worth $55.

What we would do from here is to simply sell out the put ... NOT exercise it!

If we sold out the put at $55, after buying it originally for $2, we'd still get our $53 profit to offset the $60 loss in the stock.

But, we now still have our stock position. We still own our 500 shares of XYZ Corp, but at $47.

You might wonder where I came up with that. It really is simple. All I did was to keep the shares and calculate in the $7 loss.

With the stock now trading at $40, stock ownership with a $7 loss would imply a $47 stock purchase price. My new effective purchase price of XYZ Corp. is $47 with the stock trading at $40.

A Small Loss Now Could Pave the Way to Bigger Profits Later

You might point out that I still have a $7 loss, and you would be right.

However, if XYZ Corp. was actually Goldman Sachs or Apple or JPMorgan (Symbol: JPM) or any other stock like that, I would be very confident in seing some kind of bounce-back in the very near future, as we have seen in this past year.

This bounce-back could not only make me back my $7 loss but could also quite easily leave me with a substantial profit, as many investors saw this year in many stocks!

Think about our XYZ example here. The stock traded down from $100 to $40. Just using something as basic as Fibonacci, a technical analysis tool, we could very well see a bounce-back in the lines of a 38% retracement.

If you are not familiar with Fibonacci retracements, I suggest you get familiar with them very soon. Anyway, Fibonacci says that the stock will likely retrace 38% of the movement it just had.

In our example, with XYZ Corp. stock trading down from $100 to $40, that's a $60 sell-off. Take 38% of that $60 and you get about $23. 

According to Fibonacci, the first retracement level is 38% of the previous movement, so we can expect a $23-or-so bounce-back target.

If we get that bounce-back, that would take our stock from $40 back up to the $63 area. If this does indeed happen, then our effective purchase price of $47 in the stock (courtesy of our protective puts) would wind up netting us a $16 gain -- which includes the $7 loss we acquired during the big sell-off!

This translates into a 34% return in a stock that we originally purchased at $100 and is now trading for $63.

And you thought options were risky!

'Puts are Your Pals'

For all this to work, we needed two things: for the market to cooperate and to be in a stock that was more affected by the overall market movement itself, as opposed to a specific movement of that stock due to an internal problem of that company itself.

Nonetheless, without the puts, this would not have been possible.

Without the puts, we would have needed the stock to climb all the way back to $100 just to break even, and that is a highly unlikely scenario.

With the puts, however, all we need is a much more likely bounce to $47 to break even. And with a relatively possible Fibonacci retracement, we could be looking at a 34% profit instead of a 23% loss.

This is why we used to say on the trading floor that “puts are your pals.”

There is an even-more-optimal technique that can be applied and that pertains to the replacement of the stock with in-the-money options like I mentioned in last week’s article. I will talk about this in more depth in next week’s article, so stay tuned!





Ron Ianieri
Contributing Editor
The Tycoon Report



TUESDAY, OCT. 20

8:30 a.m. Housing Starts and Building Permits

    * Importance (A-F): This release merits a B-.
    * Source: The Census Bureau of the Department of Commerce
    * Release Time: 8:30 a.m. Eastern around the 16th of the month (data for one month prior).
    * Raw Data Available At: http://www.census.gov/const/www/newresconstindex.html

Housing Starts are a measure of the number of residential units on which construction is begun each month. A start in construction is defined as the beginning of excavation of the foundation for the building and is comprised primarily of residential housing.

Building permits are permits taken out in order to allow excavation. An increase in building permits and starts usually occurs a few months after a reduction in mortgage rates. Permits lead starts, but permits are not required in all regions of the country, and the level of permits therefore tends to be less than the level of starts over time.

Highlights

    * New housing starts increased 1.5% in August to 598,000 units, exactly what the consensus forecast.

    * Single family home starts declined (-3.0%) for the first time since March.

    * Multi-family construction rose 25.2% to 119,000 units. Unlike single family units, multi-family construction is extremely volatile and is very difficult to predict.

    * Building permit authorizations increased 2.7% to 579,000. As with the new housing starts, the increase in permits was all in the multi-family sector. Single family permits fell 0.2% to 462,000 permits while multi-family permits rose 15.8% to 117,000.

    * Housing completions declined 5.5% to 760,000 units. Broken down, single-family completions fell 1.6% while multi-family completions declined 11.7%.

Key Factors

    * Single family unit construction generally follows a very smooth growth trend. The interruption of the current trend can either be a blip in the data or more likely a slight kink that will push estimates for housing starts lower over the next couple of months.

    * The construction sector continues to face problems on multiple fronts (e.g., falling prices, rising foreclosure rates, higher unemployment), and the decline in single-family homes would actually spell relief to the sector in the long run. However, the market is itching for a return to normal (i.e., pre-bubble) construction growth and will be disappointed until it occurs.

Big Picture

    * Housing starts are at extremely low levels and the outlook is not likely to improve any time soon due to high levels of inventories of unsold new homes.  An uptrend in construction will require an improvement in employment and income, and then take some time as inventories need to be reduced.  Government action to boost mortgage lending may also help, and starts might stabilize in the second half of the year.


8:30 a.m. Producer Price Index

    * Importance (A-F): This release merits a B-.
    * Source: Bureau of Labor statistics, U.S. Department of Labor.
    * Release Time: Around the 11th of each month at 8:30 a.m. Eastern for the prior month.
    * Raw Data Available At: http://stats.bls.gov/news.release/ppi.toc.htm

The Producer Price Index measures prices of goods at the wholesale level. There are three broad subcategories within PPI: crude, intermediate and finished. The market tracks the finished-goods index most closely, as it represents prices for goods that are ready for sale to the end user.

At all stages of production, the market places more emphasis on the index excluding food and energy, referred to as the core rate. Food and energy prices tend to be quite volatile and obscure trends in the underlying inflation rate.

Though the market reaction is determined by the month-to-month changes, year-over-year changes are also noted by analysts. The index is not revised on a monthly basis, but annual revisions to seasonal adjustment factors can produce small adjustments to past releases.

Highlights

    * Producer prices rose 1.7% month-over-month, a much greater rate than expected in August. Consensus forecast a rise of only 0.8%.

    * A closer look at monthly data shows that the increase in the month-over-month headline inflation was due to a strong rebound in both oil (8.0%) and food prices (0.4%).

    * Excluding oil and food prices, the core index rose a much more modest 0.2%.

    * Finished consumer good prices increased 2.3% in August after falling 1.5% in July. Increased car prices (0.7%) pushed up consumer durable prices 0.3%. Capital equipment prices increased 0.3% after declining 0.2% in July.

    * The intermediate materials, supplies, and components stage of processing group posted a 1.8% month-over-month increase in August. As with the finished goods, most of the increase was due to higher energy prices as core intermediate prices increased only 0.6%.

    * The crude stage of processing group increased 3.8%. The details are a little more troubling. Even though energy prices rose 6.9%, a decline in food prices pushed core crude prices up 6.0%. Much of the increase in core crude prices was due to a large increase in iron and steel scrap prices (13.5%).

Key Factors

    * The increase in PPI should not give inflation hawks worry about runaway inflation. The year-over-year PPI index has declined nine consecutive months including a 4.3% decline in August.

    * At this time were are not worried that the increases in the early stage of process groups will pass through to the headline numbers, but we are going to watch the details more closely over the next few months.

Big Picture

    * PPI trends were highly volatile in 2008, mirroring the trends in global oil prices.  Falling global commodity prices and weak economic demand will keep inflation in check at the producer level.  If global economies remain weak in 2009, as is widely expected, inflation at the producer level will be insignificant.  There may even be concerns about global deflation.

Source: Briefing.com