Hedging for Disaster - 3 Ways to Save Your Assets in a Market Collapse

And we're OUT!!! 

That's right, we've had enough of these idiotic market moves and, after discussing the idea with our Members all week, I sent out Alerts this morning that we will be cashing out our main Virtual Tracking Portfolios ahead of what we consider market conditions that are simply too unsafe to hold large, bullish positions in.  

We use our Short-Term Portfolio mainly to hedge the much larger, bullish positions in our Long-Term Portfolio, which is "only" up 35% but we also use the STP to make opportunistic calls, like our short calls on SCO and NLFX (click to enlarge).  

Since going to CASH!!! means we'll have lots of money for opportunity trades, which are up 214.5%, I don't see it as a big negative that we're taking down our Long-Term Trades, which have relatively slogged along since we last went (mainly) to cash in May.  

"The tree of liberty must be refreshed from time to time with the blood of patriots and tyrants" is what Jefferson once said (and we are LONG overdue for a revolution in this country) and Phil says the tree of your portfolio must be refreshed from time to time by cashing out winners and losers alike and taking a nice, fresh look at the market.  

It's not like we can't find anything to make money on.  Over at Seeking Alpha we've been running a 5% (Monthly) Portfolio, with the goal of making 5% per month using various option strategies.  We began trading it on August 8th (Saturday with an introduction) and it hasn't been a month but, already, our closed positions are indeed up net 5.5%:

If we can find 8 trades in less than 30 days that make a quick 5.5% (66% annualized), why fear going to cash?  Cash is what keeps us flexible.  Cash is, by far, the best possible thing to have in a crisis and it doesn't suck in a bull market either - especially when the Dollar is rallying anyway.   

If I were going to keep anything, I'd be keeping our Material Stocks, as those are both beaten down a bit too far and they make a nice hedge against cash positions.  In fact, USO, for example, is still open in the 5% Portfolio (now called the Option Opportunities Portfolio for marketing reasons) so the big loss in that group is only one leg of a trade we're sticking with.  In fact, as they are small and diverse, let's review our remaining positions:

As you can see, the remaining open positions net us out flat so we need to seriously consider why we are still in them.  

  • BID - We KNOW, for a fact, that Sotheby's had a bad Q2 because they moved a major auction to Q3 and we also know that auction made record sales when it went off in early July.  We closed the first two legs of BID with a $700 profit and we're sitting on a big loss on the remaining Jan. calls but I still think $40 is a good target after Q3 earnings are reported in November.  The question then becomes - are we willing to ride out a loss if the whole market turns lower and yes, we are, as I wouldn't mind spending more money to turn this into a long-term position.  
  • DIA - We took this spread last Monday, when people were panic-selling and got great prices.  DIA is well in the money at $163+ and this position will return $8,000 if it stays over $159 and the current value is just net $2,400 so no way we'd cash this in early and, in fact, I love it as a new position if you want to be bullish.  If the market fails our weak bounce lines today, we will cash in some or all of the calls ($7.70) to turn more bearish on the trade.  
  • RJET - This was a funny one as they are negotiating with the pilot's union and, as is often the case in these kind of negotiations, someone said that labor's proposals would bankrupt the company, which led to a frenzy of selling which we jumped right in on.  As Buffett says: "Be fearful when others are greedy and be greedy when others are fearful."  
  • CCJ - This one has been disappointing as we were playing for the restart of nuclear programs in Japan and Europe but both countries have had issues in getting plants running again and I'm not sure how patient we want to be on these. 
  • TASR - Taser is our Stock of the Decade but, unfortunately for you, that decade started 5 years ago, when TASR was unloved at $4.  Now it's at $23.45 (up 480%) and halfway to our 10-bagger goal of 1,000% gains).  As the spread in this portfolio is a 2017 spread that pays back $10,000 from a net $1,700 cash entry (488%) if TASR holds $25 into Jan 2017 - this is not one we'd be getting rid of.  
  • USO - Oil makes us nervous as the only reason it's over $45 now is HOPES that there will be a surge in demand this weekend and HOPES that OPEC will cut production.  Since it's already up 20% from $38 on those hopes and dreams - I'm leaning towards cashing these out ahead of the weekend.  In fact, let's take that profit (up $3,060 on a net $690 credit spread = +343% in 3 weeks) and run! 

See, that's how we got through a portfolio - evaluating each position NOT based on what we paid for it or whether it's ahead or behind but based on whether or not we believe in it GOING FORWARD.  As the great Pumbaa said: "You've gotta put your past behind you!"  

8:30 Note:  Non-Farm Payrolls just came out and they were a disappointment at 170,000 and I just said to our Members in our Live Chat Room:

Aug NFP is up 170,000, which is a HUGE miss of 220,000 expected by leading economorons.  There were 40,000 upside revisions to the two prior reports and unemployment is still very low and U6 is down to 10.3%, which is the lowest since Aug 2008, so not TOO terrible and, of course, it keeps the Fed at the table (no way they raise rates next week off that number) for another month, at least.

So bad news is good news and a great opportunity to cash out those longs! 

The markets spiked briefly higher but it was simply an opportunity to short the Futures at Dow (/YM) 16,200, S&P (/ES) 1,930, Nasdaq (/NQ) 4,200 and Russell (/TF) 1,140.  As noted previously ("Using Stock Futures to Hedge Against Market Corrections"), the Futures are a fantastic way to hedge your portfolio when the rest of the markets are closed.  

The 5% Portfolio's positions are not too different from the positions in our Short-Term and Long-Term Portfolios, only there are more of them and we don't have a hedge (we had TZA, but we cashed it in a bit too early).  So now, per our headline, let's talk about ways to protect those positions you are unwilling or unable to get out of when market conditions turn ugly.  

We post our technical levels on a regular basis in our daily posts at PSW and at our Chart School, so I won't bore you with WHEN is a good time to be more bearish here.  The premise of this article is we're sufficiently worried about China, Japan and Quantitative Tightening that we would rather be in cash or mainly in cash than attempt to hedge a large portfolio (much larger than where we started!) against what could be another major market correction.  

That chart may not scare you but it sure scares me, especially when this next chart shows you that 82% of the NYSE stocks are already BELOW their 200-day moving averages.  

I've mentioned before that it's very hard to get bullish when stocks like NFLX ($101.06, we're short), AMZN ($504.72, we plan to be short) and TSLA ($245.57) are still trading at dot-com bubble-level multiples.  We like to invest in realistic markets with realistic valuations and this is neither.  Also, if oil stays below $50 into the end of the year (and it probably will) the hedges that have been supporting oil stocks will begin to crumble and that sector can drag us down even further.  

On Monday we predicting things would turn sour this week and our trade idea from that morning's post was to play the ultra-short Nasdaq ETF (SQQQ):  

  • Buying 10 SQQQ October $22 calls for $4.20 ($4,200) 
  • Selling 10 SQQQ October $28 calls for $1.90 ($1,900)

That hedge is net $2.30 per option ($2,300 for 10 100-unit contracts) and pays up to $6 ($6,000) if SQQQ rises above $28 (again) into the October options expiration (16th).  As of yesterday's close, the $22 calls were $4.50 and the $28 calls were $2.22 for roughly the same net ($2.28), so this hedge is still good and each $2,300 you invest can gain up to $3,700 (160%) in just 42 days if the markets are weak.


But what if they are not weak?  Well, you won't lose all of your $2,300 at once and let's say you want to protect a $100,000 portfolio from a 5% sell-off.  You don't have to hedge against the whole loss - just mitigating the loss is fine and $3,700 is a good amount of mitigation (74%)!  Not only that but SQQQ is already at $25.73, so this spread is $3.73 in the money, which is $3,730 - a profit if the Nasdaq does anything but go higher from here.  That's how we like to construct our hedges!  

Now, you can hedge the hedge by finding a stock you REALLY want to own, preferably in the same index, if it gets cheaper, and selling puts against it.  A short put obligates you to buy a stock at a certain price and let's say, for argument's sake, that stock is TASR (remember TASR?), which is already very cheap at $23 and we certainly wouldn't mind owning 1,000 shares of it at $20 ($20,000).  

That being the case, we can sell 10 Jan 2017 $20 puts for $3.80 and that puts $3,800 in our pocket in exchange for the obligation to buy TASR for $20 (at the discretion of the person who paid you) between now and Jan 2017.  As TASR is well over $20, you face no danger of being assigned at the moment and the margin requirement on the short puts is about $2,000 - certainly not a big deal and, again, you have to REALLY want to own the stock - THIS IS NO JOKE!  

So now you have this lovely SQQQ hedge and the short TASR puts for a net credit of $1,500, which puts $1.50 in your pocket and, if you do end up getting assigned 1,000 shares of TASR, your net is just $18.50, which is 21% below the current price!  If there's a short-term sell off and then a long-term recovery (which we expect), you can win on both sides of this trade.  

Now let's talk about a much more aggressive hedge:  The Russell has, over the last week or so, been holding up better than the other indexes.  That makes it an attractive short, especially considering it fell all the way to 1,080 last Monday (now 1,130).  Here we can use the ultra-short ETF (TZA) to make a more aggressive hedge with a huge upside:

  • Buying 20 TZA Oct $10 calls at $2.20 ($4,400) 
  • Selling 20 TZA Oct $13 calls at $1.00 ($2,000) 
  • Selling 10 TZA Jan $10 puts for $1.00 ($1,000) 

The net of that position is just $1,400 and TZA is already trading at $12.06 as of yesterday's close.  At $13, the spread pays back $6,000 for a $4,600 gain (328%), which is an amazing ROI and your downside worst-case is owning 1,000 shares of TZA at net $11.40 (because of the $1,400 cash you put in) for $11,400.  

In order for TZA to go to $10, it has to drop 17% and, as it's a 3x ultra ETF, that means the Russell has to rise about 6%, back to about 1,200.  So the negative side of this bet is that you don't believe the Russell will be over 1,200 on Jan 16th.  Let's say it's at 1,300 (above the year's high).  That would be up 170 points from here, which is 15% and that would drop TZA 45% to $6.60 and the loss on the $10 puts would be roughly $4.80 or $4,800.  

Keep in mind the point is to hedge a $100,000 portfolio so your long positions should be UP $15,000 on that kind of mood and all you are doing is POTENTIALLY giving up 1/3 of your profits, which is what allowed you the piece of mind to let it ride in the first place!  

Finally, let's look at a more conservative hedge.  The main ultra ETF on the S&P (SDS) has only 200% leverage, which makes it far less volatile than the others.  For an S&P hedge, we can move out a bit longer term with:

  • Buying 30 SDS March $23 calls at $3 ($9,000) 
  • Selling 30 SDS March $28 calls at $2 ($6,000) 
  • Selling 5 AAPL 2017 $70 puts for $4.35 ($2,175)

Now, it doesn't HAVE to be AAPL, it can be any stock you want to buy for a 36% discount that is also our Stock of the Year pick.  In this case, the net of the spread is just $825 and you need to think of this as an insurance policy that the S&P will not go lower than 1,250 for the next 6 months.  If it does, you get paid - up to $15,000 for your $825 insurance premium (+1,718%) and your worst downside case here is "having" to buy 500 shares of AAPL at net $71.65 ($35,825) and yes, I'd love AAPL to be a huge portion of my portfolio at $71.65 and - if you don't feel the same - THEN WHY ARE YOU NOT IN CASH ALREADY???

Happy hedging and have a great weekend, 

- Phil