Friday File Part One: Hedging
by Travis Johnson, Stock Gumshoe | January 26, 2018 5:15 pm
Outlining my new (simple and limited) hedging strategy
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Source URL: https://www.stockgumshoe.com/2018/01/friday-file-part-one-hedging/
Question: I have considered placing a similar hedge in my portfolio, ( I may wait till March) but I am curious what you think about placing the Puts on QQQ? I have heard that the stocks that drive most of the market run-up often suffer the most in the downturns. I wondered if it might be as effective to hedge there? My portfolio also might be a little more speculative and tech heavy.
It’s generally best to hedge using something that’s most likely to move similarly to your portfolio — I haven’t checked the numbers, but I suspect hedging with the QQQ would be substantially more expensive given equivalent percentage moves and timeframe.
I was convinced the market would dive about a year ago and bought SDS and SPXU ETF’s. Obviously a very expensive mistake. I’ve read the Buffet approach is to just hold regardless, since the stocks will come back and timing is impossible. I did buy more stocks early 2008 which worked out well. Whether or not to sell or short the market during a crash is one of the most confusing things about investing. For me, doing little or nothing has worked out best.
That has generally been the wiser approach, and a successful one, and mostly not because of the difficulty of selling to stop losses but because of the difficulty of buying back in at an opportune time (because you’re still congratulating yourself for avoiding the carnage, and don’t want to wade back in).
That’s essentially why I like this trade, it gives me the intestinal fortitude to hold on to a larger equity portfolio than I’d otherwise feel happy about at these valuations, since I know there’s every chance that the stock market could shoot up another 20% from here (or, of course, fall 20% or more). Having some real protection, at minimal cost, makes it easier to hold. And though I am risking 1% of my portfolio on what is essentially market timing, I’ve risked 1% on dumber or equally risky things plenty of times — no matter how wrong I might be about the timing of the hedge, it still only costs me that 1% position I committed.
I keep 10% open stop loss orders on practically all my positions. In the event of a widespread market downturn, I’ll retain most of my capital plus whatever gains… and reassess what to get back into as prevailing circumstances become clearer.
During the 90’s, my “system” was buying fast upward moving stocks and a 15% stop loss. Since it was a great time to be in the market, it was a profitable approach. During the dot-com bubble, I became frustrated with the approach as I watched stocks drop more than 15%, I’d sell, only to watch them turn around and shoot way way up. The wild swings drove me crazy and I dropped that approach to a buy and hold. The lesson I learned is stick to whatever system works well for you, because most average out to the upside. Over time, the market goes up. Constantly changing systems is typically when you lose. BTW, not only do I love the approach of this NL to figure out teaser ads, but also the comments of subscribers.
Thanks joenw, we’ve surely got the best readers in the business.
Having a strategy and sticking with it is indeed one of those huge challenges — we all look for ways to change when the sands shift, but we forget how foolish our little reptilian brains can be in their urge to follow the crowd.
A strategy that’s consistent and fairly simple really helps when something wild happens — you want to think about your strategy and try to envision hot it might work out now, when the sun is shining, not at that undetermined point in the future when everyone’s rushing for the lifeboats. Better yet, write it down so you can have a rational thing to read when you’re panicking on some future dark day.
It’s that “clarity of prevailing circumstances” that is often elusive to me in a downturn.
Hi Travis, what’s the best way to hold physical precious metals? do we keep them with us physically or use some thrid part repository interms of allocated or allocated metals? Your thoughts and insights are hightly appreciated.
I hide them in my sock drawer.
Kidding.
I don’t particularly like the idea of large scale far-away vault rentals — safe deposit boxes and safe and/or secret storage in or near the home make more sense to me, at least for
The relatively small amount of physical space required for holdings at my level.
Travis , I am using the same method as you .. they way I look at my 1 % hedging cost is that it is roughly the same as what an advisor would cost me , except he can not protect me against losses. The only thing I do a bit different is that I only go out about 6 months and I tend to roll them after a big runup to recapture some premium and lock in a higher strike. Alternatively there are structured products for sale that will give you 100% of your principal back plus a percentage of the upside of the underlying index ( sometimes 100% ) .
Thank you for the great lesson on hedging. I had heard that term, but was unsure just what it was, and how it worked. Old minds like mine (80 yrs) take a bit more info to assimilate and formulate a working idea.
TJ,
how and when do you cash in the “put” hedge?
How did the “call” on QQQ start and end?
I just can’t wrap my head around Options.
I’ve been an Irregular for a long time so I should understand but I don”t.
Omg ditto thx for asking this!
Years ago I used to buy call options on stocks I thought would soon go up. Some did, some didn’t. It was fun, like going to a casino and like a casino, good way to lose money. For me, the best way to learn profitable option trades was by subscribing to Motley fool option letter and just do what they said to do. The service breaks it down by beginner and advanced trades. The steps are clearly defined . The thing I’ve found you have to be really careful of is when the brokerage option trade screen is up, make sure you’re in the correct column for either puts or calls. These trades are nearly all selling options, not buying, which is where you make money. Just make sure you have enough cash available if the option buyer exercises the option, which can happen anytime, not just the expiration date.
Same question as above. Difficulty getting my head around puts and calls
Ditto x2 !
We have not mentioned taxes here. For Travis’s position in FB, he could be up several hundred percent. If he sold it in a taxable account, a large chunk of his investment would be given to federal and state taxes. It would not be available to invest in something else. Hedging with put options allows him to keep all his FB gains working for him in the market.
Thanks for the questions on options, I’ll try to go into that in more detail later (though I don’t typically get into the greeks and the technicals).
Almost all options are bought and sold without actually dealing with the underlying stock. You buy a put option to purchase the right to sell a Stock (put the stock to someone else) at a given price… you buy a call option to purchase the right to buy the stock (call it away from someone else) at a specific price. I’m that case, the transactions would be a “buy to open” when you want to purchase it and a “sell to close” when you want to sell back your rights.
If you don’t sell to close by the expiration date, your broker will likely act to exercise the option for you even if that’s not what you want, so remember to keep an eye on the option around exploration.
Prices quoted for options are per share in the brokerage trading screen, but each option contract represents 100 shares, so multiply the price by 100 to get the current cost of a single 100-share contract. And bid/ask spreads for almost all option contracts are wide, with little liquidity, so be mindful of that. Basic commissions are usually similar to stock commissions at most discount brokers, but they do also tack on per-contract fees that add up quickly if you’re buying more than a couple contracts.
But the basic mechanics of it are that when buying these options you “buy to open” and purchasing that option contract gives you the right but not the obligation to exercise the option… and if you want out, either to take profits or to cut losses or for whatever other reason, you “sell to close” the contract.
Selling options is more reliably profitable and provides fewer daydreams of wealth (better odds, less dramatic return if you’re right), and is essentially the opposite — you sell to open to offer someone else the option at a price (in which case, since you’re selling the option you DO have the obligation to fulfill and your broker will set some of your account aside to meet that potential obligation), and buy to close if you want to get rid of the obligation.
More later, but hopefully that shows the basics. I show my options positions but don’t often write a lot about them, they are generally high-risk and low-cost speculations or ways to slightly lever-up an equity position I like… other than this hedging position, which is a whole different kettle of fish.
I often look at it this way: options let me do something small and crazy, and that keeps my inner gambler happy and keeps me from doing something big and crazy.
Thanks for this precious article Travis 🙂
I ckecked on my brooker (De Giro, I live in France) and I was only able to find this option : US SPX500 currently priced at $ 2.865,36 so 10x the SPY.
If I buy this one, would that correspond to the same option you took ? I can’t find any dates or anything…
I don’t know what that is, I’m afraid. Options contracts need to have a buy/sell direction (put or call), a strike price (the price at which you would buy or sell), and an expiration date. European options are also typically different from US options — in the US the option can be exercised any time before the expiration date, traditional European options can only be exercised on the expiration date.
#SPX / $SPY
Hi chojnowski, In the US we have 3 indexes (Dow Jones, NASDAQ, and S&P 500), and the S&P 500 is about $2,865 , so I’m thinking that might be what your broker was seeing. (There’s one called the VIX which measures volatility too, but it’s not listed with the others, which show sales.) Those are just for informational purposes, you can’t actually buy them.
In the USA you can buy $SPY, which is a fund that contains stocks that are listed on the S&P 500, but I have no idea about in France. I’m betting another Gummie will know though
Thanks Travis and Catherine for these details. I will contact my broker to know how to get these options 🙂
Have a great day
This hedge article now seems especially prescient. I will be trusting Travis’s market forecasting as the gospel. 😉
Ha! I really hope you don’t have to frame that and put it on the wall when you’re living in a cardboard box 🙂
Travis,
Glad you shared this and thanks for the site, it’s great!! I’ve been concerned lately about how to protect myself to the downside. I’ve never used options. I was looking at Cambria’s $TAIL “inverse”etf which 96 % 10 yr. treasuries and the rest SPX put options 3.9% and cash. Very low volume though and i don’t see people jumping in unless it’s a prolonged drop. It’s only been in existence since April 2017.
You may not see this till after today’s close, but depending on the shifting winds i might buy $DXD into the close and possibly $BIS since i’m overweight Biotech, but it’s not that liquid either.
edit – if you have any opinions on the TAIL etf, i’d like to hear them, otherwise i was just talking out loud.
Thanks,
Larry
Thanks for the explanation last week on the SPY put. Bought several contracts on 29 Jan and boy o boy that worked like a champ! Thanks for sharing.