Hedging Strategies to Protect Yourself Against a Market Drop


With the big run-up in stocks this year and many people expecting a pull-back or an outright bear market, perhaps you’re getting nervous and looking for ways to protect the gains you’ve made.  Hedging refers to taking positions that will reduce your loss should the market drop while still allowing for gains should the markets continue to perform well.  Today I thought I’d discuss some hedging strategies for those who are looking for a little protection.  Understand, however, that any hedging strategy you employ will reduce gains in the future.

In speaking about hedging we’ll assume that the investor is primarily long to start with, meaning that the investor will make money if the stocks he/she owns go up in price.  (When you buy a stock, bond, or mutual fund, you are “long.”  When you sell short or buy an option that goes up in price when a stock goes down, you’re “short.”)  Most people are long most of the time and this makes sense because the market’s long-term tendency is always up.  Being short for a long period of time would be like entering a turbulent river and expecting to travel mostly upstream.  Hedging a short position can also be done just by doing the compliment of the trades I describe.  For example, buying a call option instead of a put option.  (If you are not familiar with options, check out Options Trading: QuickStart Guide – The Simplified Beginner’s Guide To Options Trading or a similar book.)

One often associates hedging with risk, largely because of the term, “hedge fund” applied to the high risk/high return funds purchased by wealthy individuals.  These funds get their names because they can take long or short positions, but often these funds are not hedging.  Instead they are using large amounts of leverage to make large gains from relatively small movements in the markets.  This causes a substantial risk of losing money.  True hedging actually reduces risk.

To hedge is to take up positions that are designed to offset long positions, such that the investor will be less susceptible to losses due to falls in the market.  For those who play roulette, you would be hedging a bet of $100 on red by putting $50 on black as well.  You would be reducing the amount you would win if red were rolled since you would lose the bet on black, but you would also be reducing your loss should black be rolled since your small win on the black bet would reduce the loss on the red bet.   If an investor is perfectly hedged, he/she will not lose money no matter what the market does.  But by taking up these positions, one also limits or eliminates the possibility for making gains while the hedges are in effect.  The following are ways to hedge a long position:

Selling shares of the same stock short-  This is also called “selling short-against-the-box” and forms a perfect hedge provided that equal numbers of the shares are sold short as are held.  No matter the movements in the stock, no money will be gained or lost.  (Note that if the stock price goes up an investor would need to add cash to the account or pay margin fees, since this would result in  negative cash balances in the account).  Selling short-against-the-box has little purpose other than delaying gains from one year into the next for taxes.

Selling shares of other complimentary companies short-  In this strategy, the investor sells short shares of a company that he/she expects to decline if shares of the company he/she owns fall in price.  For example, if he owns McDonald’s, he might sell shares of Wendy’s short, figuring that is the market turns against fast food companies shares of both companies will fall.

Buying put options- A put option is a legal contract by which someone agrees to buy shares of a stock for a predefined price before a certain date.  This can be though of as an insurance contract on the shares of the stock.  In exchange for this agreement the owner of the shares gives the seller (called the writer) of the put a certain amount of money, called the “premium”.  For example, a put option for selling 100 shares of XYZ stock at 50, good for three months, might cost $300 when the price of XYZ was at $51 per share.

Writing covered calls on the stock–  Here a contract is written that allows another individual to purchase your shares for a fixed price.  This limits the amount the investor can make on the shares (since if they go up above the agreed to sales price they will be purchased for the sales price) but reduces losses somewhat if the shares decline in price due to the premium collected.

Buying short ETFs– This involves buying short exchange traded funds (ETF).  These are financial instruments that are designed to go in the opposite direction of a particular market segment or index.  For example, an owner of several mining companies might buy a short basic materials ETF as a hedge against a fall in commodities prices or a slowdown in goods production.

Selling a portion of the position The simplest way to guard against losses in a position is to simply sell some or all off the position, and is probably the best thing to do if you really need the money in the short-term since it is the most cost-effective way to be safe.  This, of course, reduces the possibility of future gains, however.

If you’re interested in individual stock buying and this strategy, I go into far more detail in my book, SmallIvy Book of Investing: Book1: Investing to Grow Wealthy.  Check it out at the link below if interested.

Have a question?  Please leave it in a comment.  Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. 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. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

The Stock Price is All About the Dividend (Even When They Don’t Pay One)


A couple of years ago I got into a lengthy discussion of stock pricing with a reader.  Unfortunately the exchange ended up being by email (I’d much rather readers post comments to the blog – I get so few of them).  I contended that stocks are priced based on the dividend they pay, or actually, based on the potential future dividend.  The reader basically said that I was incorrect and that stocks are based on a lot of factors, the dividend being a very minor one.  (In actuality, we’re both right, and I’ll explain why in a minute).  In any case, he cited Apple as a company that would never pay a dividend; therefore, the idea that it was priced based on potential future dividends was ludicrous.  A few days after our debate, Apple announced that it would start paying a quarterly dividend of about 2%.

How is he right?  Stock pricing isn’t like pricing at the supermarket.  You don’t walk in, pick up an item from the shelf and see a price sticker on it.  (Yes, I know that we’ve gone to bar codes now, and the price (might) be on the shelf, but bear with me – I’m from the 80’s.)  Prices fluctuate constantly and for a wide variety of reasons.  Some people look at earnings and decide what a stock should be worth.  Some look at how likely it is for the stock to have an earnings surprise and bid the stock up accordingly.  Some people sell shares and don’t care what the price is because they have a large profit and just want to unload it, or they need to pay for their daughter’s wedding.  Some people see a stock go up or down in price, and buy or sell it because it went up or down in price.  They figure that if the price is going up, they’ll be able to sell it at a higher price.

Very few of these people are probably thinking about the dividend that the stock is paying.  Heck, a lot of these stocks may not even have a dividend.  So I must be wrong, right?

Well, even though all of these people don’t know it, they are basing the price they pay on the projected future dividend.  Note that the “projected future” part is very important.  Note also that there are fluctuations int he price – the dividend just sets the price range.

 

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You see, the amount that people are willing to pay for a stock depends on its potential future return.  This return must be enough to justify the risk that is being taken on.  If one can get a 5% return from a bank CD, one wouldn’t even think about buying a stock unless one thought a 8% return or greater was possible.  Why trade a certain return of 5% for a possible return of 6%?  You wouldn’t.  You would drop the price you were willing to pay for the stock until the potential return was at least 8%.

Also, the more uncertain the return, the greater the return must be.  If you are buying shares of McDonalds, for example, you can assume that the amount of traffic at their restaurants won’t change by that much during any given year.  It isn’t like everyone is going to swear off Big Macs at once.  You can therefore predict with reasonable certainty how much the company will earn during the next year (or the next five years), and therefore you know about what the price will be.  (Here you’re also assuming that the price to earnings ratio will remain about the same, which isn’t too bad an assumption.)

On the other hand, if you are buying shares of a silicon chip maker like Cypress Semiconductor, the future becomes far less certain.  You don’t know if research and development won’t pan out, or the Koreans will dump a bunch of cheap chips on the market, or what.   You also don’t know if interest in electronics will remain, or if manufacturers will choose Cypress chips or one from their rivals.  Because they are somewhat of a commodity, the fortunes of a company can be pinned to a few cents savings per chip made.  Because of this uncertainty, shares of Cypress are priced cheaply relative to shares of a company like McDonalds.  Note that the PE ratio for Cypress is 17.5, while that for McDonalds is about 18.5.  People are willing to pay a little more for more certain earnings.

But wait, that’s earnings, and I was talking about dividends, right?  Well, let’s say that a company never, ever paid a dividend.  What return would a shareholder receive?  Another way to look at it is, what value would the company be to the shareholder if he never received any share of the profits?  True the company might be making a lot of money, but the investor would never see a cent of that.  Without a dividend, there is no return to the shareholder.  He would not even see capital gains because no one would be foolish enough to buy the shares from him. (OK, someone would be, but that’s beside the point).

 

 

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So, when people are buying stocks, they are trying to figure out what the future dividend will be, and what their return would be based on that dividend, and then pricing the share price accordingly.  Granted, this is a Ouija board-type of pricing where people may not even know they are pricing it based on the dividend, but they really are.  The reason that people pay more for shares with growing earnings is that if the earnings of the company are higher, they will be able to pay a bigger dividend.  Many who price stocks based on earnings forget this fact, but that is what they are doing (that is why earnings matter at all).  It is kind of like how the main reason people paint houses is because if they don’t the wood will rot, but they are probably thinking more about how the house looks than wood rot when they decide it’s time to paint again.

Note also that the piddling 2% Apple is paying may seem small, but if you bought the shares back a year ago when the price was half of what it is now, you would now be receiving a 4% dividend on your investment.  If you continue to hold the stock and the dividend continues to increase, you effective yield will continue to climb.  You might be making 8%, 12%, or 20% in five years.

So, dividends do matter, even if many people have forgotten that fact.  When it comes to pricing, it’s all about the dividend.

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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.

It’s not the individual choices – It’s the habits


 

I’m still making my way through Darren Hardy’s The Compound Effect.  One of the things I’m beginning to understand is that it isn’t the individual choices we make that set our destiny so much as the habits we form.  For example, right now I’m trying to lose the 50 pounds or so I gained back after dropping the same weight several years ago.  The last time I lost weight it was because I had changed my habits.  I regained it when I changed them back.

You see, back in my mid-thirties I realized that I was going to die young if I didn’t lose some weight and start exercising.  I started jogging about 3/4 of a mile in the morning, then walking back.  This continued three mornings per week for about three or four weeks (and I hated starting every time, but was always glad when I had finished my jog), at which point I was able to jog all the way out and back, running 1 1/2 miles per morning.  After this I would walk around the block (another 1/2 mile or so),  After a month or two of doing this, I started running around the block instead of walking after going out and back, increasing my total to about 2 miles.  Finally, after doing this for several months, I increased the distance I went out, upping my run to about 2.25 to 2.5 miles.  At that point I decided the run was far enough and running farther would just wear out my body.  I was able to run 5K’s and actually registered a time in the mid 20-minute range.

The Compound Effect

I also changed how I ate.  Instead of cleaning the plate when I went out to eat, I would eat about half and then save the other half for lunch.  I found that the whole meal would be about 1500 calories, so eating a half portion was about right.  At home, I would leave one thing off, like the side of corn or maybe the potatoes.  At Mexican restaurants I would just have a few chips rather than finishing the bowl and asking for a second or a third.  One thing I noticed was that when you’re out, many of the things you do centers around food:  stopping for ice cream, pie and coffee, or just a sugary coffee drink.  I found other things to do that didn’t involve eating.

As a result I went from a high of about 248 down all the way to about 215 pounds.  My pulse had dropped to about 50 beats per minute, to the level where they would need to take a couple of readings and get one over 50 before they would let me give blood.  I had a lot more energy, my blood pressure was lower, and generally I was in good shape.

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Then life started to get in the way.  While I was exercising regularly, I often didn’t really want to get up and go out into the cold to jog since it was hard to get going to the point where I fell into a rhythm.  (After I would started, however, I discovered that actually the best temperature was about 35 degrees or so since I could wear a sweatshirt and cap and not get sweaty about half way through, so I preferred cold mornings to one that was in the 60’s or 70’s.)  When I reached about 39, however, I started getting heel spurs which would cause my feet to ache if I tried to walk after sitting for a while.  Jogging would cause the condition to worsen for several days after.  As a result, I stopped jogging as much, then finally quit entirely.  I changed my habit of exercising.

I also found myself eating more full meals when I went out to eat.  I also started getting soft drinks again in restaurants (I went to water before).  Worst of all, I started doing more business trips and vacations, where I would be eating out every meal and having a big breakfast at the hotel.  (I normally didn’t eat breakfast, so that added another 50 to 800 calories onto my diet each day.)  I went back to 220, then 230, then into the 240’s.  Finally, after a few holidays and trips, I found myself in the 250’s, higher than I had ever been.

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From reading The Compound Effect, I realized that what got me into such great shape was that I changed my habits.  It wasn’t the first day I went jogging or the choice of having water at lunch instead of a Coke one day that made me lose weight and get into shape, it was the habit of doing those things.   Likewise, changing habits back to eating full meals out and drinking a soft drink more often than not when we went to a fast food chain caused me to go right back to where I had been and then some.  Once again looking at an early fifties heart attack, I’ve changed back, cutting my meals and counting calories to stay below 2000 per day.  As a result, I’m down to 242 again.  I plan to stay with this, and start jogging again after I lose another five pounds or so (so that it isn’t as hard on my heels) and keep those habits this time.

So what does this have to do with personal finance?  Well, just like with losing weight and getting healthy, putting yourself onto a firm financial footing doesn’t mean doing one thing and then going about your life.  If you stick $100 into five shares of Intel Corp today and never do anything else, you won’t retire a multimillionaire.  But if you put away $100 every week or two and invest regularly, you’ll find yourself in 20 or 30 years financially independent.  It isn’t the individual choices – it’s the habits that make the difference.

So what are your habits?  Are they good, taking you where you want to go, or bad, holding you back and making you unhealthy or poor?

Join the conversation and help make this blog more exciting!  Please leave a comment.  Also, if you have an investing question, email  vtsioriginal@yahoo.com or leave the question in a comment.

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.