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New Harbor: Hedging 101

How to defend against a market correction
Saturday, September 13, 2014, 2:02 PM

This week's podcast builds on our recent report on hedging, driller deeper into how the technique can be used to offer protection against falling asset prices.

There are numerous ways to hedge, which vary in cost and complexity -- with several being quite simple and low-cost (such as building cash or employing stops). But many investors don't practice them, mostly out of unfamiliarity. Which is a shame, as often a small degree of defensive planning can provide substantial avoidance of large losses. (In fact, our recent poll has discovered that one of the most common and cheapest methods of hedging -- setting stops --  is hardly used by PeakProsperity's readership.)

In this week's discussion, we review the pros and cons of the most popular hedging techniques, as well as when and for whom they are appropriate to consider. Those unfamiliar or not actively hedging currently will benefit most from listening and determining which may be worth considering discussing with a professional financial adviser.

Transparency note:  As a result of our public endorsement, Peak Prosperity has a commercial relationship with New Harbor. The details of this relationship are clearly presented in writing during the referral process -- but the punchline is, our relationship does NOT result in any increased fees to those who become clients.

If after listening to this podcast, you find yourself interested in connecting with Mike, John, and the rest of their team to learn more about their advisory services, please use the form here to do so.

cheers,
Adam

It should go without saying: this discussion should NOT be construed as individual financial advice by those listening to it. The content should be taken as informational and educational in nature only. Investment advice must be tailored to your specific personal situation (which we and our guests are obviously unaware of) and should be obtained directly from a financial adviser you trust. Before acting on any of the statements made in this podcast, we advise you do just that.

Click the play button below to listen to my interview with New Harbor Financial  (53m:34s):

Transcript: 

Adam: Welcome to today’s Peak Prosperity podcast. I am your host, Adam Taggart, and today we are going to talk in-depth about hedging. As discussed lately on our website, the stock and bond markets appear dangerously overvalued at this point. For example, the S&P, which has risen 200% in more or less of a straight 45-degree line since 2009, has not experienced a 10% correction in over 34 months. And, since the end of 2012, it has dropped to test its 200 daily moving average zero times. Forgetting for a moment about the many fundamental reasons why this market should correct, just looking at the technical warning signs that are multiplying, it seems increasingly likely that a correction is near if not imminent. And, with a lack of prior dips to let out the building pressure, this one could be a doozy.

So, how can the regular investor reduce the impact a nasty correction can wreak on their portfolio? Well, there are a number of investment vehicles that can offer insurance against lower prices in much the same way your home or car insurance offers protection. The practice of using these instruments is called hedging. Here to talk with us about the ins and outs of hedging are Mike Preston and John Llodra, lead partners at New Harbor Financial. New Harbor is the financial advisory firm officially endorsed by Peak Prosperity. And, for full disclosure, we have a business relationship with them, which we always disclose when we have them on the podcast, which you will find within the write-up that is going to accompany this discussion.

And, so now, let’s dive in. Mike, John, are you guys ready to talk about hedging?

John: Sure.

Mike: Hi, this Mike. Thanks for having us on the podcast today.

John: And, hello, this is John. Hello, Adam and hello to the listeners out there.

Adam: Great. Well, guys, thanks for joining me today. We have had a lot of interest in this topic since we published the most recent piece on the site that sort of gave an overview of hedging. And, I want to get a little more in-depth into the material here with the two of you. So, I guess starting, in New Harbor’s sort of professional perspective, what role does hedging play in portfolio management?

John: Well, I can start us off there, Adam. This is John again. Well, you know, just—and I think it is very appropriate at the outset here to really talk about really what is hedging. And, we will start it at a real elementary level here, because I am sure there are many different levels of understanding on the part of your listeners as to what we mean by hedging.

First, let me make it very clear that there is no free lunch. Hedging is by no means a free lunch. In fact, by definition, hedging approaches—strategies, if you will—have a cost to them. And, that cost is either in the form of an outright cost, paying for some form of insurance, or in the form of lost opportunity. You know, in other words, giving away some potential upside in return for some protection against a downward, adverse move in a position that one might hold. And, really when evaluating the timeliness or appropriateness of hedging, an investor really needs to ask themselves—and I say this somewhat rhetorically—but, do they believe that there is downside in the market? Certainly, any given day, you can go to CNBC and see any number of articles where one is left to believe that the market is certainly going to go up and the only question to be asked is how much is it going to go up.

So, we have noticed in many of the folks we have spoken to in the last 12, 18 months, that though they may theoretically or intellectually understand that markets go down, how they are positioned, many of these folks, speaks that they believe that there is not a likelihood of a downturn. They might be fully or nearly fully invested. So, one really needs to—hedging really needs to be based on a premise that markets not only theoretically can down, but have a likelihood of going down. And, therefore, the cost of hedging can be justified in the sense that it is likely to be less than the cost of an un-hedged portfolio in the event of an adverse, downward move against a position that one holds.

Adam: Good. Well, thanks for that clarity. I mean, I tend to think of it, again, I think I used the word "insurance" in the introduction. But, I think of it a lot like insurance, just the way that my family of four, we are probably going to spend somewhere around $10,000 this year in health insurance. And, that is largely to protect against a large healthcare bill should one of us have a really serious accident or illness. And, at the end of the year, while I sure wish healthcare insurance costs were lower, I am usually very glad if I do not have a big illness or a big accident that requires hospitalization. Meaning if my insurance actually does not get called into use, it is actually a good outcome. And, it sounds like you're saying that is sort of the way to be thinking about hedging here, that it is a regular cost, the way that your monthly insurance bill is. And, if at the end of the year, there has not been a disastrous market crash, it means that your core positions have done well and you actually should be pretty grateful. Is that a good way to look at it?

John: Absolutely, a perfect way to look at it. It is basically saying, “Yeah, there’s some potential for a catastrophic event, one that I can’t afford to be unmitigated against, so therefore I’m willing to pay something—again, either an outright cost or a lost opportunity to protect against that potentially catastrophic event.”

Adam: Okay. Great. So, with that in mind, as you take on clients who understand that and perhaps maybe have not hedged before, how do you look at a portfolio when you are constructing and determine how best to apply hedging to it?

Mike: Adam, this is Mike. I think I will respond to that. Going back to your analogy just a minute ago, the health insurance premium, I think it is a very good analogy. There are some slight differences, though. For instance, as long as you are alive, you are going to need health insurance. There are times to have insurance in your portfolio, in your investment portfolio, but it is not all the time and I want to make that distinction. We do not necessarily want to be fully invested and then have insurance all the time in every environment. There are other ways to hedge or to reduce risk in a portfolio. In the scenario that we find ourselves in now, here today in September of 2014, the environment is highly risky. You mentioned some of the technical factors early on in this call. We could layer in some fundamental factors on top of it. But, suffice it to say, this is one of the very few handful of the riskiest times this market has seen in the last 70 years or so.

So, having said that, we first and foremost want to reduce risk right away, and that means coming off a fully, 100% or even 80% invested portfolio that might be invested in stocks or stock mutual funds. So, the first thing we are going to do is raise cash, and we are going to get down to an equity allocation we feel comfortable with, given the fundamental and technical environment. And, for us here at New Harbor, that is down below 20% stocks right now.

So, when you ask how do you—from our perspective—how do we construct a portfolio? First, we get down to a risk level we feel comfortable with, and then we are going to look at what remains and what of that remaining exposure do we want to hedge. For instance, we have some exposure into some areas that we think are undervalued, like precious metals miners, mining stocks. We have an associated hedge with that mining exposure. We have got less than 10% in mining stocks, but we have a put option that will give us a floor, which that position cannot fall below. And, we will essentially offset losses below a certain point. The same goes with some precious metals that we hold in accounts.

So, there is really a lot of other things to think about, too. I think I will pause there for just a minute and maybe hit some other points in a second.

Adam: Okay. But, your key point there is that, obviously, one of the things that a financial advisor does is sort of assess the makeup of the market and then creates a hedging position that is appropriate for the given market condition. And, so there might be times where markets are looking dangerously overvalued, obviously, hedging probably needs to be deployed more aggressively then. There may be times after large sell-offs or what not, where hedging might be less required or less appropriate, or at least maybe different types of hedging might be more appropriate in certain conditions versus others. Is that accurate?

Mike: Yeah, that is accurate, Adam. What you are really talking about there is the difference between hedging and speculation, in my opinion. It is important for the listener to understand the difference. Hedging is something that you do to avoid a large loss. So, if you have to have a fully invested portfolio for some reason—and some people do, because, they might have highly appreciated stock that they are not willing to sell, or for some other reason they have to stay exposed to the stock market, you are going to want to make sure that you carry a hedge of some sort in most market environments, certainly in the present market environment. What we are doing here, for the most part, is hedging. Even though we think we are in a fundamental and technical environment that is almost certainly going to be disappointing for people that are long the stock market—another way of saying that we think the stock market will go down—we are still not speculating on a market decline.

So, the difference to us is, when you are hedging, you are still in a—the market is in a rarified air, like it is now, however, it has not done anything wrong yet. The market really has not gone down appreciably yet. And, so that is an environment that we think is ripe for raising cash and hedging what exposure that you do have. However, if we start to have a material breakdown in the market, followed by a continued breakdown in internals, and we start to see a trend change to the downside, potentially with some rallies back to resistance, then we are going to see a different character in this market. And, that could be an altogether different story. Then, you may very well, or we may very well consider doing some more speculative-type trades versus just straight out hedging.

Other things that we would look at when deciding how to construct a portfolio and how to hedge that portfolio would be to take a look at the tax structure of the account. If it is an IRA account, it is quite easy to reduce equity exposure, not worry about cash considerations and raise a lot of cash. And, if one is really concerned about the market, it is hard for us to argue that that is not the right thing to do, to simply just raise cash in the IRA. But, as I mentioned earlier, in taxable accounts, you might have highly appreciated stock or concentrated stock that might be inherited that you cannot really sell without very large tax consequences. In that case, we would want to use some different strategies to hedge. For instance, specific strategies that we might get into later, like cashless collars, which involves selling calls and buying puts on some of those concentrated positions.

Adam: All right. Well, why don’t we start actually introducing what some of the vehicles that can be used to hedge are? And, while I know this can get really, really complicated really, really fast, I think we will just try to keep it at a high level and then sort of direct people to how they can learn more about that certain, more complex flavors if they are interested. But, the piece that was put up on the site this week, I think, talks about the major ones, which I will recite here. And, if I am missing anything major out, just let me know. But, I think most of the common vehicles that, at least I know of, that are used for hedging, at least at the individual investor level, are stops, inversed and leveraged ETFs, going short, options—call options, put options are the most basic ones—and futures. Is that pretty much the main set that the individual investor should be thinking or right now, or is there any more we should add to that list?

John: Yeah, that pretty much covers most of the bases, Adam. There are certainly all kinds of variants and combinations of these tools that one can put together to get as complex as they want to be. But, again, hedging need not be a complex exercise. It can be as simple—and we prefer, actually, the simple, straightforward approaches based upon good conviction and fundamentals.

Adam: Okay. And, I know this is going to be hard to have you guys sort of succinctly discuss each on a call of the length that we are going to be on. But, let’s try our best here and just try to give people at least a little bit of an understanding of what each of these, the pros and cons are, and how New Harbor might consider using them when they are looking at a portfolio and trying to figure out how to best hedge.

So, why don’t we start with stops? I guess two questions for stops, one really quickly, at a high level, what do you use a stop for and when is it appropriate to consider?

John: I can take that one, Adam, this is John. So, really, when we are talking about a stop, what we are really talking about is a sell discipline. One of the things that we try very hard as investment managers to be is disciplined, both in the entry and exit of positions. We want to have a reason for entering a position, but we also want to have a kind of a discipline about what would cause us to exit that position. Because, as the saying goes, you can only spend the gains you keep, and to actually cash in on gains you have to sell at some point. So, stop orders are really a way to impart a sell discipline. Most brokerage firms have very easy user interfaces to set up stop orders.

There are a couple of variants of stop orders. You know, again, we do not want to get too detailed here, but there is what are called "stop market orders" and "stop limit orders." And, they are slightly different. So, in a stop market order, basically what happens—and, let’s assume you are long in stock and you want to sell at some point below where the stock currently is to avoid the possibility of further loss. So, a stop market order, basically, would have you say I want to sell, well, say if the price of a stock is at $100 and one wants to impart a discipline to sell at $95. They will enter a stop market order at $95. The way that works in practice is, if that $95 level is hit in the gyrations of that stock, it turns that sell order into a market order, basically saying, “Okay, I want to sell my shares now.” And, what that does is it guarantees the owner of those shares that they will sell their shares, but it does not guarantee the price at which they will sell their shares. All it does is once the price hits $95, the shares are sold to the market at the market price. And, if the stock continues to fall, for example, you might get some of the shares executed at $95, some might get executed at $92, some might get executed at $90 and so forth. Of course, it could go the other way. The market could rise, hit $95 and spike higher and you might actually sell your shares higher than $95. So a stop market order guarantees an exit, but does not guarantee the price.

A stop limit order is a way you can guarantee that you will get that $95 price, but you are not guaranteed to get a complete fill. So, it might hit $95, you might sell one share of your 100 shares, and the market might drop or rise considerably from that $95, and you are not filled on any further of your order, because you have specifically said, “I only want to sell at $95.” So, in that case, you are guaranteed the price, but not the quantity of the sale.

Now, one important thing I would like to point out—and this is really where we spend a lot of our time—you can certainly pick arbitrary price levels at which you want to enter stop orders. But, we think there is great value in using technical levels, support and resistance levels, for example, that the market has shown to be sticking points for a stock. Use those levels in defining a strategy for setting stops. Now, most individual investors will want to set hard stops so that they can live their lives and play golf or go to their day job, or whatever, without having to sit in front of their screen all day. We here, typically, use what we call mental stops. We have a discipline, but rather than have a hard-set order in our system, we would rather be pulling the trigger manually, so we can kind of work the order more tactfully, if you will, in light of the minute-by-minute gyrations of the market.

So, we can certainly spend a whole call on stop orders and how they are used, but that kind of scratches the surface anyways.

Adam: Okay. And, so it seems like a very common, human dynamic is to—once you are in a hole, begin to really rely on hope that you are going to get out of that hole, which in the impartial markets probably is not a winning, successful strategy. So, you look at stops as really sort of, as you were saying, a discipline. A mental discipline that you set in advance to say, “Look, if this stock goes against me, my stop is going to keep me from basically getting into that vicious cycle of just praying it’s going to go up again as the stock continues to go further down.”

John: Yeah, absolutely. So, it is a way to keep yourself from talking yourself into doing stupid things, basically.

Adam: Great. And, so how common a practice is this something that you guys use at New Harbor? Is it something that you use frequently, or only for certain types of positions?

John: There is not a position we enter that we do not have some exit plan or rationale for why we would exit. So, whether it is a specific price target or a specific price target combined with kind of market behavior of that security—whether it is volume or kind of technical patterns. So, we use them as a matter of routine in our position management for every position that we might hold.

Adam: Okay, great. So, fairly commonly used instrument. All right. Let’s go on to the next one here, the inverse ETFs and then the various leverage flavors of that. And, to explain leverage really quickly, an inverse ETF usually tracks some sort of underlying security or index. And, that means if the index goes down a percent, if it is an inverse ETF, roughly it should go up a percent, the inverse ETF should go up a percent. Leveraged ETFs just simply use leverage to increase the price relationship, so that if the underlying security goes down one percent, a 2X-leveraged ETF would go up two times and a 3X ETF would go up three times. I know that there are some time decay and other issues that get in there, which maybe you can talk about, guys. But, let’s talk about the leveraged ETFs for a moment. Very quickly, do you have anything more intelligent to say about them than my quick summary there, and how often do you guys employ them?

Mike: Adam, this is Mike. I think your summary was very good. In our view, inverse and leveraged ETFs were really created to bring alternative strategies to the average investor. And, they make some alternative strategies like shorting an index or a market, or investing in a commodity either long or short—it makes it much easier for the average individual to take a position in those markets. Traditionally, the easiest and purest way to take a position in those markets would be to use futures, and we can talk about that potentially a little bit later, just briefly. But, for those that do not really have the ability to use futures accounts or outright shorting of securities, these ETFs have made it very easy to do so. And, it is really a huge boon for those that have most of their money in IRA accounts, because really, it is one the very few ways that you can short a market in an IRA account through an inverse ETF, whether it is 1X, 2X, or 3X. And, of course, there is lots of caveats that we can talk about, people have to be careful with in terms of tracking error and decay and things like that, as you mentioned.

Adam: Great. And, we should probably talk about shorting really quickly, just because I think we want to contrast shorting versus owning an inverse ETF, briefly. Can you guys just give a quick summary of what shorting is?

Mike: Absolutely. And, while I respond to that, I realize I did not answer your question about how often do we use inverse and leveraged ETFs and/or shorting. So, I will kind of tie those together. In general we do not use inverse or leveraged ETFs that often. We will wait for a material breakdown, as I talked about earlier, in the market and if there is a technical reason to do so, we very well may use inverse ETFs to participate in shorting the S&P 500 or some similar index. We are almost certainly going to use a non-leveraged version, because it is safer and has less tracking error. For instance, we would probably use like a 1X short ETF on the S&P 500.

So, we will use them when it is appropriate to do so. In terms of—you asked, though, questions about shorting. Shorting is a more pure way of participating on the downside, either at an index or an individual stock. You could simply borrow shares in and index fund, let’s say, that tracks the S&P 500, and then sell them in the open market—called
"shorting." So, you borrow them from your broker, you sell them in the open market, and then you buy them back later on at presumably a lower price, or hopefully a lower price.

The nice thing about shorting directly is that you get very good tracking with the actual index. You do not really drift very far over time. An index, or an inverse ETF—certainly the leveraged ETFs—have what is called "tracking error," because they only track the market movement on a day-to-day, point-to-point basis, and in a very volatile market, you could have a compounding of tracking errors that happens on a daily basis that really adds up to quite a bit over time. That same thing does not happen when you directly short either an index ETF or an individual stock.

Adam: Okay.

Mike: So, just a couple of quick caveats there. To be able to short a stock or an index ETF, it has to be borrowable, it has to be on the list of securities that you can borrow from your broker. And, then when you short that stock or index ETF, you do owe whatever dividends that security might pay out while you are shorted, because you borrowed it from somebody else to sell it. So, there is a time component, or a cost, a dividend cost. With the S&P 500, it is not that high right now with a current dividend yield of about one and a half percent or so, maybe a little bit more. Being short the S&P 500 via an index ETF will cost you roughly that same amount, about one and a half percent to the negative, to pay out the dividend.

Adam: Okay. So, if I can just summarize, because I know the difference—if you are not familiar with these instruments, the deeper we get into the weeds, it gets a little bit harder to understand one versus the other. But, sort of the way I look at it is that if you are going to be holding something for a shorter period of time, consider an inverse ETF more strongly. Because, if it is for a shorter period of time, that tracking error is less of a factor. If you are going to place a negative bet over a longer period of time, consider shorting.

I know that one of the additional risks with shorting, beyond having to pay dividends that might be declared while you are short, or things like that, is unlike an inverse ETF, the most you can lose with an inverse ETF is the initial principle that you put in. In theory, if the trade goes against you, your holdings could theoretically go to zero. So, if you put a $1000 at risk, you lose $1000. With shorting, as I understand it, because you are betting against a stock, and a stock has no theoretically limit to its upside, your losses technically have no theoretically limit when you are short, unless you employ some sort of protection like a stop order that we talked about earlier. And, I think in the case of a short, you would actually put in a buy stop order, meaning when your trigger got hit, you would buy back the stock to close out your short. Is that correct?

Mike: That is correct, Adam. You would protect a short position by placing a buy stop order at a technical price that you think, if it breaks through to the upside, is likely to keep going, you would place a buy stop order above that technical level. Maybe this is getting a little bit too complicated, but there are other things you can do, too. For instance, you can buy calls, which will give you the right to buy a stock at a higher price. That would also protect your short position.

Adam: Okay. Great. Well, that is a pretty good transition to where we are going to, I think, head next to briefly talk about options. Before we close out the short versus inverse ETF discussion, it sounds like you guys do not use these as much as you use stops. Are they ones that you use from time-to-time in the arsenal? And, if so, just when are the main instances in which somebody should be considering either one of those?

John: Well, this is John again, Adam. I want to make sure we always kind of remember the distinction between hedging and speculating, because it is very easy in a discussion of shorting to confuse the two. Again, if you are just shorting a stock or an index, and you do not otherwise have a position that is related to that index, that is not hedging, it is speculating against, on a move, which is a fine strategy. But, recognize it for what it is and what the premise for that trade is.

So, by and large with the caveat that we said, we find that the inverse ETFs tend to be a little more easy to use in a typical client’s account for several reason, not the least of which, again, for shorting positions, you need to have a margin agreement on file. And, we tend to hold short positions, certainly in the hedging context or even in an outright short position for a very short period of time. So, some of the tracking error considerations that we talked about, do not tend to be material for us. And, they are very, very easy to trade. We are always focused on liquidity and ease of trade, and there have been few instances where we felt we cannot accomplish with an inverse ETF what would otherwise need to be accomplished by shorting a specific security.

Adam: Okay. Great, great. Well, that is really good to summarize there. So, it sounds like when staying on the hedging side of the hedging-versus-speculating line, ways to apply both. But generally, for the individual investor, usually use these in short bursts. Inverse ETFs tend to work just about as well as shorting, yet give you the protection of not having that open-ended downside that you have with shorting.

John: That is right.

Adam: Great. All right. So, let’s move into slightly more complicated or complex instruments. Let’s move into options. Mike, you had just mentioned call options, but if you could just give a really quick summary of what an option is and the different between the two main ones, call options and put options. We can then talk really quickly about how they are used to hedge.

Mike: Okay, Adam. This is Mike. I am just going to cover them briefly, and if you think I should go into more detail then I will. But, in the interest of time and trying to stay within the scope of this podcast, I will try to keep it brief.

A call option is a right to buy a security. So, if I want to buy the S&P 500—I am just going to stay with something very broad here—I can buy a call option, and that will cost me what is called a premium, to buy the S&P at a certain price. So, here with the S&P 500 roughly around 2,000, darn close to it, at 2,000 I can buy a call option to buy the S&P at 2100, let’s say. And, so that is 100 points, or about 5% above where we are right now. And, I could say, “I want to buy the S&P 500 at 2100 anytime between now and, let’s say, January.” So, a call option—all options, actually—will have a strike price, in this case 2100, and an expiration date, in this case, January. And, usually, it is the third Friday of every month, so that would be the third Friday in January that the option would expire.

Now, I am not actually looking at a quote screen right now, so I am going to just make up some numbers. But, that particular option might cost something like 15 points, 15 points, or $1500 per 100 shares. So, if the S&P were to go up above 2100 and by expiration it remained above 2100, I could then go ahead and buy the S&P 500 or the ETF SPY as well at 2100, no matter how high it went. It could go to 5,000 and I will still buy it at 2100. Now, of course, it has to go above 2100 for me to make a profit at all, and frankly, it has to go above 21 plus the option price I paid for me to even break even. If you think about it in this example, it has to go to 2100, plus the $15 premium I paid. So, it has got to go to 2115, or else I will not make any money. I will lose the entire premium paid if it closes below 2100. So, that in a nutshell is a call option, a right to buy.

The put option, on the other hand is a right to sell, and that is where we use puts, that is why we use puts as insurance in portfolios. So, with the S&P 500 trading at around 2000, we might say, “Okay, we want to buy a put option, which gives us the right to sell the S&P 500 at some point in the future at some lower price." It does not have to be a lower price, it could be the same price or even a higher price than we are presently at. But, in the context of what we do, it is usually at a price below. And, it really fits very well into the analogy of the insurance you talked about earlier, because then you could choose your deductible. So, say the S&P 500 is trading at 2,000, I might say, “Well, if it drops by 10% or more, I want to start to have some insurance kick in.” In that case, you would buy a put option with a strike price of $1800, so 10% than we are right now. And, you would pick an expiration date. I will stick with the same January, the third Friday in January expiration. So, that option might cost $10, let’s say. So, if the S&P 500 stays above 1800 between now and January, that option will expire worthless and we would lose our $10. However, if it did drop below 1800, no matter how far below 1800 it dropped, we would have the right to sell the S&P 500 in this example at 1800. And, so here the math works out for the breakeven point at 1800, minus the premium paid of 10, anywhere below 1790, we are actually making a profit on that position. If it is a speculation we would call it a profit, if it is a speculative position. Otherwise, if it is a hedge, it is simply offsetting losses in the stock component.

So, in as few words as possible, those are the two main types of options.

John: Adam, I would just like to kind of tag onto Mike’s great introduction there. In the context of hedging, particularly given what we have hopefully clearly made as our view right here and now, that downside risk in the stock market is significant and perhaps even more likely than upside moves from here, I want to make a point that both kinds of options can both be bought and sold. And, Mike used the example of buying a call option at a higher price. Now, right here and now that is not a trade that we would be inclined to make, because that is a bullish trade. More likely, we would be inclined to sell a call option against an underlying investment that we have. Again, it could be the S&P 500 or some other long stock position. And, by selling an option, we get paid a premium from the market. So, that premium does afford some downside protection, whereas a put option gives you an absolute protection below a certain level. Selling call options, otherwise known as "covered call selling," provides some degree of protection, but that protection is limited to the amount of premium that you take in. And, we can combine these strategies together to, for example, do what is called a "costless collar," where we sell a call option and use the proceeds from that call option to pay for the cost of the put option on the downside. So, it can be made to be a costless collar, so to speak. Just wanted to make that clarification in light of the environment we are now in, and what we would be more inclined to do with call options right here and now.

Adam: Thanks. I am really glad you did that, you shared that example, because I sort of think a lot of these instruments we are talking about here are sort of like Lego pieces or tinker toys, where you can put them together in all sorts of different combinations to create all sorts of more intelligent hedges that just the basic building blocks alone allow you to do. And, it can get very complicated very fast, and even if somebody did not follow exactly the logic of how you just described the costless collar—although, I think you did a great job explaining it—I hope it at least gets across the point that you can combine these things together to create really powerful forms of protection. And, in certain cases, ones that can provide better protection and even the potential for either more upside or a safer form of upside than each one of these things individually.

And, we will get to this in a moment, but this is one of the reasons why, especially as you get into using the more complicated forms of hedging, you really want to work with an advisor. One, because it takes time to understand how to use these instruments safely and understand their behavior, but secondly, you really want to be able to leverage somebody’s expertise who knows how to combine these things in really effective ways like you just described there with the costless collar.

All right. So, I would imagine in today’s market, having options are probably a fairly compelling form of ways to hedge downside risks to consider for a couple of reasons. One, because they have that leverage factor, where, I think as you said, Mike, typically underlying any individual options contract is 100 shares of the index or security that you are buying the option on. And, one of the ways I think of options is it is a way to commit a limited amount of money for a disproportionately high return if your hedge actually, indeed gets exercised. And, of course, if it does not, just sort of like health insurance, that you have paid the premium and you “lose the premium," you do not get it back, but at least it was giving you insurance while you had it deployed. Is that a fair to think about it?

John: Yeah, I think that is very concise and very accurate, Adam. And, I would just mention again that options also give you the ability—and it is easy to understand on the put side—they give you the ability to pick a deductible, so to speak. If you have got concentrated stock positions, or you are highly invested in the market, you can choose how much of a downturn you can tolerate, that the larger the downturn you can tolerate, the further out of the money the puts that you could buy for that particular portfolio or account. And, of course, with some calculations that you have to do to decide how many puts to buy, but if you can tolerate a 25% downturn, then you would be buying puts on the S&P at 1500 or so. And, the further out of the money that you buy, the cheaper it is for that insurance. But, of course, the higher the deductible, just like health or auto insurance.

Adam: Right, right. And, we are skimming over a lot of the complexity of options here. There is a huge time decay factor in options and the pricing of options is—in fact, it is a very sophisticated and very non-linear pricing mechanism. There is a famous calculation called the Black Shoals Theory, that is used in valuing options. They tend to be incredible sensitive to the volatility of the underlying stock. We are not going to get into all that detail here, but it is important for us to emphasize—and again, the main reason why I am emphasizing this is just to underscore that the average person should not just wade in and start trading options without any prior experience by themselves. It is really something that you should get experienced with under the guidance of somebody who understands them well. And, as you will hear me reiterate a lot, both on the site and in this podcast, starting with a financial advisor that is seasoned in their use and really learning from them how they deploy them is really the best way to start.

Guys, anything about that you want to add?

John: I think you tied it up nicely there, Adam.

Adam: All right, great. So, just in the interest of time, I want to briefly, very briefly just mention what futures are. I do not think futures are something that many average investors should be dabbling with, at least early on in their hedging forays. But, it is something that is useful to know, and again, it is something that I think under the guidance of an experienced financial advisor, the right type of individual investor could be considering futures. So, if one of you guys could just give a brief overview of what it is and just opine on the type of person that perhaps should be considering futures, who it might be appropriate for, that would be useful.

Mike: Well, I think futures accounts would be appropriate for fairly sophisticated investors that understand how to use them and understand the leverage that is involved. Futures accounts, if used properly, are wonderful—the futures are wonderful tools, because they really are a pure form of being able to take a long or a short position in many different commodities and stock market indexes. Essentially, if just we stick with the S&P for a minute here, you can buy or sell the S&P and you can pick a contract month for delivery. Typically, it is anywhere—it is generally about 90 days out is when each contract expires. And, for very little money or very little margin, you can control a heck of a lot of stock.

So, for instance, with the E-Mini S&P 500, that contract is worth $50 a point, and if you think about the S&P at 2000, $50 times 2000 is $100,000 worth of stock, okay. So, you can buy or sell $100,000 worth of stock in a futures account with only about $5,000 margin required. That is a 20-to-one leverage ratio. And, it is also very pure in the sense that there is really no tracking risk involved, as we talked about earlier with inverse ETFs, and there is not really many moving parts like options, for instance. It is very simple. You can expect to have a negative drift or time loss of about one and half percent on the S&P 500, because of the dividend that I mentioned earlier, though you are not actually paying out the dividend. The futures market is priced so that it is really the same as being short the stocks in the S&P 500. Otherwise, it would be an arbitrage opportunity.

But, if you are sophisticated and you want to hedge this way or even do speculations this way, it is a great way to do it. I would add that you do not have to have a futures account, though, particularly in instruments like the S&P 500. You could simply use an ETF like SPY, and 500 SPY is roughly equivalent to one E-Mini S&P 500 future. So, it is going to take more cash. You will not get nearly as much leverage out of it, but you can buy or short S&P 500 through the use of SPY, which is not a leveraged ETF, it is just a regular market ETF. And, you can mimic a futures account that way. However, a futures account will let you do a lot of other things like buying and selling gold, silver and other commodities that can only be done in a futures account.

John: And, one thing to add and reinforce there. Any time we talk about leverage, it can do great things for you when a position moves in your favor, but it can do equally bad things for you if the position moves against you. So, there is no free lunch, not here, not anywhere.

Adam: Well, thanks for underscoring. And, just for the last word on futures, it sounds like for the sophisticated—and I am also going to assume larger investor, given the leverage involved—futures may make sense. It sounds like they offer a lot of the same way to sort of make a leveraged bet the way that options do, but with fewer moving parts and a simpler structure. But, it sounds like for the average investor, who probably does not have really large positions to put a hedge on to protect, they could probably do a lot of the same thing using ETFs. Is that accurate?

John: That is exactly right. And, we should probably point out that we do not use futures for clients. You have to be a specially registered entity to do a lot with futures. We find that we could adequately get done what we need to get done without the use of futures.

Adam: Okay. So, glad you said that, because if you are sort of an average investor listening to this podcast, I think it is good to know what futures are, and that there might be select cases in the future where they might apply to you. But, really focus your attention on the other instruments that we have talked about more than futures.

All right, guys. Well, we have, I think, done a great job of summarizing some relatively complex topics, hopefully in a distilled, understandable way for the folks that have been listening. A couple of quick questions for you as we wrap things up here. I guess, can you tell me right now, given where the market is, how is the core New Harbor position hedged at the moment?

John: I can summarize that for you, Adam. This is John. So, again, we talked about raising cash as one form of hedging, perhaps the cheapest form of hedging, just simply getting out of risk assets to a large degree. And, then, obviously, some of the other tools we talked about. Right here and now, we actually are big proponents of holding a large amount of cash. And, getting back to that insurance analogy on your auto, sure you can have insurance and it can protect you against an accident. But here in New England, we are about to see winter set upon us in a few months and there are some times where it just does not make sense to take your car out of the garage. Because, you could have the best insurance policy ever, but it still makes sense not to drive because of the ice or snow or whatever might be out there. That is the equivalent of holding cash. Sure, you can hedge a position, but sometimes it makes sense not to drive, and that is kind of the way we size up this market right now. For a good portion of a client’s portfolio, we just do not believe it makes sense to drive. We are talking 40%-50% cash in a lot of instances.

That which remains, we do have some hedges in place. Right now, ironically, because we are holding so much cash, we have fewer hedging instruments, because cash is our preferred way to hedge. But, we do have some, for example, out-of-the-money put options on gold and gold miner positions, because there is fundamentally a good case we can make for those. Technically speaking, and particularly of late, the technical case has gotten much more muddied. In fact, you might say negative. So, we do believe there is merit in having some downside protection there on the precious metals and mining-type investments.

We do have a spread transaction, if you will, where we have an inverse position on the Russell 2000 index and a commensurate long position on the S&P 100 index. And, the basic premise there is that the small caps have been, as measured by the Russell 2000, they are more overvalued on a fundamental basis than they have been on a technical basis, much weaker in a relative strength kind of sense to the large cap. So, we believe that, certainly in a downward environment, we believe there is a good likelihood that the large caps will drop less than the small caps. And, that spread in such a scenario would likely make some positive return.

I got to emphasize that everything we say here is not meant to be an investment recommendation to any listeners, that hopefully is abundantly clear. But, those are two kind of hedges we have in place right now using some of the tools we talked about. But, right now, our preferred form of hedging is holding cash.

Adam: Okay. Yeah, I find it fitting and little disturbing to—I grew up in New England and, John, to hear you sort of use the analogy of sometimes it is just safer not to take your car out of the garage, given the weather outside... Comparing the elevated level of risk in today’s market to a Nor’easter, I think is very accurate and just very scary that that is where the market is these days. But, I think it is a great analogy.

And, since you are sitting, sounds like more in cash than you are normally, because it seems to be the most appropriate response given where the market is right now, let’s assume that the market does eventually correct. It becomes a more attractive environment for you to actually deploy that cash, is it correct to assume that as you begin to take bigger positions in the portfolio with that cash, that you will be employing some of the other types of hedges in greater frequency than you are today?

Mike: Yeah, Adam, that really depends upon what the market internals look like. If we see a significant or sufficient retreat in valuations that is accompanied by internals—when we say "internals," we mean things like volume, new lows, starting to contract, that type of thing, emerging sectors starting to take after making a bear market low. If we see valuations retreat and we see internals improving and looking better, we will indeed not only increase our positions and risk assets, we will very likely lift some or all of our hedges. So, it really depends upon what the market looks like. We want to make it clear that we do not think—at least from our standpoint of our strategy—we do not always hedge all the time.

John: Now, one very real scenario is let’s say we get a moderate pullback here. And, again, we evaluate things circumstantially as they happen. It is conceivable we would be compelled to want to put some more money to work in the stock market, but we may not feel comfortable in doing so without that piece being partially or fully hedged. So, one strategy we could use—and again, this is not a script, but a possibility—we could go long some stocks, a stock index, and simultaneously see a call option against that, which would bring in premiums. So, we would be long, but we would be long with some degree of protection as afforded by the premium that we would take by selling call option against that position. Countless different game plans we could have, but that is just one hypothetical example.

Mike: Yeah, that, suffice it to say, Adam, that the most likely scenario would be a retreat in valuations and we might not know if we are going to be early, and probably will be early in starting to get more aggressive, particularly early on, coming off of a high cash position. We probably will hedge those early positions. But, if the correction deepens and valuations get even better, and things like volume and breadth start to look very good, then we will start listing some hedges.

Adam: Great. Well, I am really glad for your responses to these last couple of questions. Because, really what I am trying to surface here is how does a financial advisor who does a lot of risk management like New Harbor does, how do you think about how to apply hedging, given the market environment and given what you are doing with your core portfolio. One of the reasons why—a big reason why Peak Prosperity endorses New Harbor as our financial advisor is this risk management expertise that the firm has. We have talked to lots of different firms out there. Because, a lot of these hedging instruments have a cost to them, not all financial advisory firms choose to use them. And, from personal experience, I would say it is the minority that uses them frequently, and certainly, to the extent that the folks here at New Harbor do. And, our philosophy is we really want to make sure that first and foremost we are protecting against losses in portfolios. So, we are much less interested in endorsing firms that are swinging for the fences and trying to hit grand slams all the time. We are really looking for somebody who is first and foremost taking a minimize-loss approach and is being exceptionally prudent when they do take a long position, that they know what they are going to do if that position turns against them.

So, I hope those listening have really gotten a little bit of a view inside the heads of you guys in terms of how a professional that thinks from a risk management standpoint actually processes how they make their decisions. And, I think you guys have done a really good job or sort of, in as understandable a way as possible, kind of give us an idea of sort of what are the elements and the variables that you use when you are trying to make these decisions.

So, guys, thank you. I am looking at the time here. We are just about coming up on the hour. Thank you for, again, taking really what can be a very complex subject and making it, I think, very approachable to the average listener here. As we wrap up, is there anything that you want to say in closing about the practice of hedging or you guys’ perspective on how you deploy it?

Mike: I do not think so, Adam. I think we have covered it pretty exhaustively here today, and we certainly could talk about it for a lot longer. But, I think we will say that this suffices as a good introductory lesson to Hedging 101. And, we just want to say thank you for having us on the podcast today. We really appreciate it.

Adam: Well, you are very welcome, guys. And, we will make sure, as we always do when we have you on the show here, we will place a link at the bottom of the write-up accompanying this. So that if anybody listening wants to talk to you more specifically about hedging and perhaps hedging in their own individual case with their own individual portfolios, we will provide a way for people to do that. So, Mike, you are going to regret just saying that you can talk extensively further on this topic, because I sense there are going to be people that are going to want to do so with you.

Mike: We look forward to doing that. We would love the opportunity.

Adam: Well, Mike and John, thank you guys for your time today. I really appreciate it.

John: Thank you, Adam, and thanks everybody for listening.

Mike: Thank you.

About the guest

New Harbor Financial

Founded in 2005, New Harbor Financial Group is a privately owned investment advisory firm that provides risk-managed investing and financial guidance to individuals, families and institutions. Located in Leominster, MA, we serve clients throughout New England and in many other states across the country.

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2 Comments

davefairtex's picture
davefairtex
Status: Diamond Member (Offline)
Joined: Sep 3 2008
Posts: 5072
risk management

So I think the guys at NH said what I wanted to hear at the top of the show.  Paraphrased, "we use mental stops for every position we enter" - there is a defined price (or a specific market action) which if met, will cause them to bail out because the theory of their trade was invalidated.  This is disciplined trading.  If I gave my money to someone, my number 1 priority would be to have someone who said something like this. 

Their position on cash I agree with also.  Cash is a cost-free hedge.  I'm a big fan of cash too.

I think John Hussman buys a fair number of puts for his fund - perhaps we could get him on to get a sense of just what his puts cost him as a percentage of total portfolio per year, and how much downside protection he ends up having as a result.

If you do have a taxable account with a big position with large gains on it, then hedging makes more sense.  When the market starts to look iffy, you can go short an e-mini future (or short SPY) vs your long equity position assuming the dollar amounts are similar.  And you can put a buy-stop on the short so you are taken out if the market breaks higher.

Otherwise - cash is good.  :-)

Uncletommy's picture
Uncletommy
Status: Gold Member (Offline)
Joined: May 3 2014
Posts: 476
You should have

You should have called it "Hedging Tools 101". The concept of hedging could have been explained better if you hadn't jumped right in and started to explain how the tools work. I was hoping you would have started with some of the basic concepts of what hedging is all about. You could have started with futures and explained how they work with commodities and a time factor. Buying and selling pork bellies - orange juice - wheat or even gold. Perhaps I'm being over critical, but I found it a bit confusing. It needed to concentrate a bit more on the basics of trading and not just on the tools.

Your guests, obviously knew their stuff, but I think they presented the material "under the gun" as things seemed a bit rushed. I know that many of your listeners have brokers working for them and that they can't be sitting next to their computer watching the action every minute. However, there are a couple of things that should be noted:

1. Know something about the industries you've invested in and how those particular markets operate.

2. Be diversified in your holdings and don't have all your eggs in one basket - spread the risk.

3. Yes, have a good relationship with your broker and make sure he's familiar with your goals.

4. Cash is great, but dividend producing stocks are always working for you despite what the market is doing. If Janet Yellen decides to "ax" QE, savings will just be keeping up with inflation.

5. Your assets should be working for you and not just a place to retain value. Nobody "invests" in precious metals, but they invest in sound companies that are working and producing stuff. Warren Buffet knows this very well. Indexes are helpful, but be involved with your assets whether they are fruit trees in your backyard or the market. Hedging boils down to what Barnard Baruch said," I made all my money by always selling too soon!"

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