Hedging a Stock Portfolio the Best Way – Reduce Your Position


Through the last several posts we’ve reviewed covered some different ways to hedge positions in stocks and other investments.  This included:

1) Selling short companies in the same industry or other industries that one would expect to fall along with the industry in which the investor is long:  https://smallivy.wordpress.com/2010/06/07/hedging-a-stock-position-using-short-sales-protecting-a-portfolio-in-a-bear-market/

2) Buying put options on the shares: https://smallivy.wordpress.com/2010/06/18/how-to-hedge-a-stock-position-using-put-options/

and 3) Selling covered calls, which produces income and provides somewhat of a hedge since the income from the call writing offsets some of the losses when the stock price falls:  https://smallivy.wordpress.com/2010/06/13/covered-call-writing-how-to-make-most-any-stock-pay-a-dividend/

While each of these strategies will provide a hedge, each also has its downfalls.  Because stocks can continue to go up for some time even when the market is due or past due for a fall, one may need to cover short positions before the market does finally does capitulate.  Things can also happen to individual stocks such as buyouts that cause the shares of your short sale to rocket up, forcing you to cover the position. 

Put options expire, and you may end up buying put option after put option, only to see them expire worthless.  Then the day that you forget to but a new put is the day the market will fall 10%. 

Writing covered calls is a conservative strategy, but what do you do when the stock has fallen by 10%?  Do you buy an offsetting call to close out your original position, where the call was written at a much higher strike price,  and then write a new call at the lower price?  What if the stock then goes up?  Do you close out the position, taking a loss, and then write another call, hoping the stock goes down again?  Also, what if the stock goes up 10% after you write the first call?  Do you close out the position and take a loss on the call you wrote, risking that the stock would then fall?

Perhaps the best strategy for hedging, and the only one suitable for serious investors who are investing to make a great deal of money rather than gain some entertainment, is to simply sell off portions of a position once it becomes large enough to worry about losses.  If a position seems particularly pricey, in that it would take several years for earnings to justify the current price, it is best to close out the position.  If it looks like the entire market is about to fall, it is probably best to close out some of the positions that have done really well, or at least take some money off of the table, and start pooling up resources to buy after the fall. 

One must be careful, however, in that most of the returns of the stock market are due to a few day’s worth of gains.   If one is constantly diving into and out of the market, one may miss one of those days, which could mean the difference between making a 15-20% annualized return and 5% return.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

How to Hedge a Stock Position Using Put Options


Put options are a type of insurance contract designed to prevent the loss of money when a stock falls in price rapidly.  A put option is a legal contract that gives the individual who buys the put option the “option” — not the obligation —  to sell 100 shares of a stock for a fixed price (the strike price) on or before a certain date (the expiration date).  The person who creates the put option is called the put writer since he “writes” the legal contract.  (In actuality, no physical contract is written, the person wishing to write the put option simply calls his broker and indicates he wishes to write the put option; gives the stock name, expiration date, and strike price; and then the option is created.

The strike prices for put options are at specific intervals of the stock price.  At lower stock prices the strike prices are at smaller intervals and they spread out as the price of the stock increases.  The expiration dates are also specified at regular intervals, with options expiring on the third friday of the month (for example, a June option would expire on the third friday in June).

In exchange for agreeing to buy the stock at the fixed price, the option writer collects a premium from the option buyer, just as a car insurance dealer collects a premium to ensure an automobile.  The price of the premium depends on two factors, the difference between the current stock price and the strike price, called the extrinsic value, and the time remaining on the option, called the intrinsic value.  Note that the volatility of the underlying stock is also a factor, since stocks that move up and down rapidly are more likely to move below the strike price at some point before the option expires than are stocks that are fairly stable.  The intrinsic, or time value of the option tends to stay fairly stable until about 90 days before expiration, at which point the value decays rapidly.

While options are used commonly for speculation, the only suitable use of options for serious investors is in their pure use, that as an insurance contract to protect against losses.  For example, say an investor had 1000 shares of XYZ corporation and had a good profit, but already had a lot of capital gains for the year and wanted to avoid taking the gain for a few months until the new year started.  The investor might buy 10 January put options with a strike price a few dollars below the current price of XYZ.  In that way, if XYZ fell in price before the expiration date in January, the investor would limit his loss since he could sell his shares at the strike price.  He would also lose the premium paid if he exercised the option.

Once purchased, put options can be sold and the position closed by writing another put option of the same strike price and expiration date.  For example, if our investor bought 10 January 50 put options to cover his 1000 shares of XYZ from losses, and the price of the stock dropped to 40, his put options would now be worth $10 (the extrinsic value) plus the remaining intrinsic value.  The premium might now be $11 or $12 or more, depending on how long it was before the options expired. The investor may decide that he would rather keep his shares, now that the price has fallen and seems less rich, thereby avoiding a capital gain on the stock or the costs of closing the position and buying the shares anew.  Because the investor has the option to sell the shares, rather than the obligation, instead of exercising the puts and selling the shares he may decide to write 10 January 50 put options.  This would then close the position by creating an offsetting obligation, collecting $11 in premiums, say, and he would be able to pocket the difference in premiums.  If he originally paid $3 for the put options, he would pocket ($11-$3)*1000 shares = $7000.

Note that just as few people use their automobile insurance during any given policy period, few put options expire with the stock price lower than the strike price.  Because the probability that the stock will be below the strike price at the expiration date is priced into the premium paid for the option, most individuals who buy put options will lose a little bit of money compared with just selling the shares outright.  It is therefore not a good strategy to buy put options repeatedly.  Instead, they should only be purchased when the investor wants to stay invested for a short period longer, but is worried that the stock may suffer a sudden drop in price. 

They may also be used when, for some reason, the money will absolutely be needed within a few months to a year but the prospects for the shares are so great that one does not just want to sell the shares now.  For example, there are rumors of a takeover or a short squeeze is likely.  90% of the time, however, it is better to just sell the shares if the money will be needed and avoid paying the premiums to buy calls.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

When will Housing Prices Bottom Out?


There is much speculation on when home prices will finally bottom out and start rising again.  Various government programs have been attempted that offer incentives for home buyers but they only have the effect of causing people who were going to buy a home anyway to move up their buying decision.  When the program ends the increase in sales ends with it and home prices continue to fall.  Because consumers tend to spend less when the price of their home is falling, both because they are unable to borrow from their home to pay off credit cards–freeing them up for more spending–and because they feel less rich and therefore are less willing to make purchases and go on vacations.

Likewise, attempts to halt the slide by having banks “reset” loans that are in default, forgiving missed payments, lowering the principle, and adjusting the terms of the loan have met with similar failure.  In fact, because the loan is reset the buyer starts to feel entitled to not paying if he feels that the loan is somehow unfair.  Even though he felt the price of the home was fair when he bought it, because he has seen his loan reset he fells that he deserves the value to be lowered if home prices continue to fall.  This results in a cycle of default, reset, and default, each time driving the home price further down.

Home prices, like stocks have a fair value.  Unfortunately, during the housing bubble this fair value was forgotten as individuals paid more and more for houses simply because they felt, no matter what they paid, that they could later sell the house for even more money. In the least they thought that the price of the house would continue to increase, so if they did not buy now they might never be able to do so. 

Payments through traditional 30-year fixed rate loans were above the buyers’ ability to pay.  In order to pay for the houses, individuals first began taking out took out 0% down loans since a 20% down-payment was out-of-the-question.  Later, Adjustable Rate Mortgages were used since they started at a lower interest rate.  Then individuals started taking out interest only loans where they only paid the interest, and even then the loans were taken out at teaser rates such that the interest rate was only low for the first year or two.  Finally they started taking out Option ARMS which allowed individuals to pay less than the interest amount, such that the amount owed actually increased over the first several years of the loans. 

Because they were not able to afford the payments once the loan was reset and they needed to start paying off the principle, many went into default.  This caused banks to stop making loans because they could no longer sell them to third parties, and the price of houses could no longer increase.  At this point they began to fall back towards fair value as homes are foreclosed upon and buyers reduce the bids they make for houses.  Even if they were willing to pay a high price for a home the banks are not willing to make the loan.  Until houses reach their fair value they will not stabilize and the various programs simply have the effect of delaying the inevitable.

I would submit that the fair average value of a house for a given area is about equal to the price that would allow the average  person living in that area to purchase that house and pay no more that 30% of his net income (after taxes) for that house.  Currently home mortgage rates are extremely low, owing to the fact that the Fed Funds Rate is also extremely low and all interest rates are tied to the Fed Funds Rate.  The current rates for a 30-year loan are around and unheard of 5%. 

In the table below I present the payment, net income, and total income required to purchase houses of various prices assuming an interest rate of 5%on a 30-year loan.   Note that the net income required is found by dividing the yearly payments by 30%.  The total income required was calculated by assuming various tax rates (income, Social Security, etc…) ranging from 25% to 50% of total income, depending on income level.

 Table 1: Income required assuming a 5% loan rate

Home Price Monthly Payment Net yearly Income Total Yearly Income
$100,000.00 $537.00 $21,480.00 $28,640.00
$200,000.00 $1,074.00 $428,960.00 $57,280.00
$300,000.00 $1,610.00 $64,400.00 $99,077.00
$500,000.00 $2,684.00 $107,360.00 $165,169.00
$1,000,000.00 $5,368.00 $214,720.00 $429,440.00

So, for $100,000 houses to sell, there needs to be enough people in the area who make at least $28,640 per year to meet the supply.  If there are not, the price will need to continue to drop until there are enough people.  Likewise, if there are a lot of $500,000 houses on the market, unless there are a lot of people who make at least $165,000 around looking for a house the prices will continue to fall (or the owners will need to stay in the house and not sell until incomes increase.  Note that an income of about $425,000 is needed to comfortably afford a million dollar house.

Some may say that requiring the payment to be no more that 30% of one’s net income is too restrictive a requirement, but note the effects of the recent bubble in which people were buying houses with much higher payment ratios.  While there may be some who do buy houses at higher levels of leverage, doing so puts them at great risk since any deviation in their income at all or an unexpected expense such as a car breakdown or illness can easily lead to a foreclosure, which again will drive down the prices of houses in that price range.  Such buyers will also probably feel very “tight” financially with little income left over for other expenses.

The rate of taxes has the effect of suppressing home prices.  The total income required to afford a home increases as tax rates increase because paying a greater percentage of income to taxes has the effect of lowering net income.  Because the current government drive is to raise taxes (sun setting the Bush tax cuts and enacting significant new medical entitlements), we should expect the fair value of homes to continue to fall as states and the federal government raise taxes to cover budget deficits and increase social programs.

If rates return to more historic values–either because the Federal Reserve raises them to hold down inflation when the economy starts to pick up or inflation does return and causes rates to rise on their own–the effect on the fair value of homes is even more chilling.  (Note that increases in inflation cause interest rates to increase since lenders need to raise the interest rates they charge just to get back the same effective rate of return–they are being paid back in dollars of lesser value than those that were lent).

Table 2 gives the net incomes and total income levels required if the 30-year mortgage rate rises to 8%.  Note that now the total income required to afford a $300,000 house increases from just under $100,000 to over $135,000.  Unless big raises at work come as well (which don’t look to be in the cards anytime soon), look for housing prices to fall if and when rates are raised unless they stay low long enough for salaries to catch up with housing prices.  Note that the effect is particularly severe because the higher income required means that those able to afford even a $300,000 house will be pushed into the higher tax brackets, so their total income must be even higher than before.

 Table 2: Income required assuming an 8% loan rate

Home Price Monthly Payment Net yearly Income Total Yearly Income
$100,000.00 $734.00 $29,360.00 $39,147.00
$200,000.00 $1,468.00 $58,720.00 $90,339.00
$300,000.00 $2,201.00 $88,040.00 $135,446.00
$500,000.00 $3,669.00 $146,760.00 $266,836.00
$1,000,000.00 $7,338.00 $293,520.00 $587,040.00

So in conclusion, no matter what policy gymnastics the government or banks do, housing prices will continue to fall until they hit the fair value, which is determined by the income level for the area.  If taxes are raised, the value of houses will fall.  If interest rates are raised the value will fall even faster.  The best course would be to stop trying to hold back the bursting of the dam with various gimmicks and allow it to burst so we can clean things up and regain a more sustainable path.  To do so is like trying to bail the Titanic with an ice bucket.

Like what you’re reading? Keep the blog going – Refer a friend – https://smallivy.wordpress.com

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.