I guess the point is missed if I don't write a novel every time I post.
Step 1 - We want to hedge against inflation. Step 2 - We decide to use XLE as un upside hedge to our $10K annual energy bill. Step 3 - We want to offset an 8% rise in energy prices between now and 2012.
To buy XLE straight out, hoping to make $800 on an 8% rise in the stock, I would need to buy 200 shares for $13,400. If XLE were to fall 10%, I would lose $1,340. If XLE were to fall 20%, I would lose $2,680 and if XLE were to fall 30%, I would lose $3,020.
That trade would be net neutral on the downside to my annual energy spending so I am effectively locking in $10K of spending, laying out $13,400 in cash ($6,700 in ordinary margin) to offset $800 in rising oil prices.
My original suggestion was to sell 1 2013 $50 put for $4, collecting $400 and buying 2 2012 $55/60 bull call spreads for $2.6 ($520). That's $120 out of pocket, perhaps $2,500 in margin and you make $880 EVEN IF XLE falls 10% and you don't lose more than $120 until XLE is down 30%.
Maybe it's just me but I think it's a better play. This is not that complicated and people reading this should not be scared away from options or hedging - my goal is to enlighten the average investor and open this world up to them. It's a very powerful and very underutilized tool but, like many powerful tools - it needs to be handled properly.
As someone else pointed out, prices change every day and positions change constantly - it's not enough just to jump on a position but you have to learn how to manage them over time. For instance, today the VIX picked up a little so we found a few shorts to sell. When the VIX is lower, we're more inclined to buy puts.
Yes I did mean the 2013 and of course you don't net out a full profit until the 2013s run their course but, again - if you WANT to own XLE at net $50 and are willing to be paid $4 NOT to own it - then why the aversion to this trade?
We often trade longer time periods for lower strikes if it's margin efficient. Portfolio margin usually assumes a 20% move in the stock and once you get above or below that zone, your margin requirements get very low, which turns this into a very attractive trade for margin accounts.
Obviously, if you don't have a leveraged margin account, you should stick to "cheaper" plays like the XLF or even just simply buy a bull call spread that pays well like the XLE 2013 $66/70 bull call spread at $2, which pays 100% if XLE gains 5% and holds it through Jan 2013 - no margin just a straight 100% play to hedge some upside. Those are easy and can be found on hundreds of option picking sites - we like to go a little deeper when looking for opportunities.
So call it what you will but let's say you want to put $400 into that trade 2 spreads. That offsets $400 of increased energy costs but, if XLE flatlines or goes down 10%, you lose $400.
If however, you sell the 2013 $50 puts for $400, you are in the same $400 bull call spread but now you have decided that IF XLE falls from $67 all the way to $50, you will be willing to buy 100 contracts at net $46.
Now we take that $400 from the sold contracts and that ups your net entry on XLE to $50, which is still 30% below the current price. If you don't want to be long on the energy sector in 2013 with oil around $60 - walk away from this side of the trade!
If you do think that owning $5,000 worth of XLE at $50 is a good long-term use of your funds, then take the $400 for agreeing to buy it and use it to buy 2 call contracts. If XLE goes to $70, your consolation prize for not owning 100 shares at $50 is to get paid $4 for 200 shares of the spread ($800). Last I heard, even making $800 on $5,000 is pretty good money but nobody holds $5K in margin unless they are in an IRA so it's $2,500 - $500 depending on the type of margin account you have.
Even more importantly, look at your profit window. You have a $0 cost basis UNLESS XLE falls below $50. Since the idea was to hedge $10K of annual fuel purchases, even at $33 (50% off) if your fuel costs dropped $5K then you would only lose $1,700 on the short puts and, if that ratio stayed in place, you would never lose money to the downside. So what is risk? Risk depends very much on what you are protecting.
As I said, a lot of these strategies are counter-intuitive and have to be learned just like any profession is learned. It takes time and practice and you need to develop different ways of looking at your portfolio as well as your life and goals so you can set a path towards what you really need to achieve in your long-term planning.
PS - we just got off the Qs and are very tempted to go with SQQQ at $30.50 here - of course we're using options and selling short puts but just the basic ETF has a good chance of bouncing here and $30 is a nice, obvious stop-loss.
The bottom line on these (or any) short put sales is you have to REALLY WANT to own the underlying ETF long-term at the strike you sell. If so, then you are simply allocating a percentage of your dormant cash to a position you would be willing to take down the road. We rarely move from at least 50% cash positions so having spare margin is rarely an issue - that's a big difference between stock traders and options traders.
Also, as I mentioned in last week's S&P trade idea, if you have a Portfolio Margin account - there is a world of difference in what you put aside. I thought I was being clear saying that you are, in the XLE example, COMMITTING to buiying $5,000 worth of XLE at $50 (100 shares from one option contract). Whether that commitment costs you $5,000 in an IRA or $2,500 in ordinary margin or $505, as it does on my TOS margin screen is something that very much depends on your individual account.
Options trading is not a one size fits all exercise we teach different strategies for different types of accounts and different trading goals - can't possibly cover what amounts to a year of course-work in every 3-page post unfortunately but if I refer to our educational materials or training articles I get accused of trying to sell my service (heaven forbid!) so there's no way to make 50,000 people at SA happy, is there?
For a while I told them not to pick up my weekend articles to Members because we do touch on fairly advanced issues that require a bit more than a casual familiarity with risk management but SA cut the part where I mentioned that our service is all about helping people learn how to manage and adjust these trades over time so what can I do?
Anyway, if you want to learn option basics, you don't have to give us money. Market Tamer is an excellent service that specializes in teaching option strategies and they have a 14-day free trial and then just $147 a month. If you sign up you get a free copy of the same book that we give to Members on our own site so, if you want to learn more about basic options trading - try them at bit.ly/gQjaui
PS - Seeking Alpha edited the hell out of this post because it contained a special offer for Membership - you can read the unredacted version on our site: www.philstockworld.com.../
That's why most people don't hedge - it's counterintuitive.
That's also why we spend months and years teaching people how to hedge their portfolios - it's not the kind of thing you can get a "cheat-sheet" on.
Hedging is a whole other mindset for investors that needs to be practiced over time and learning how to do it properly is as real a course of study as any pursuit you will go for in college. It's a shame they don't teach this in business school but it's the first course you get when you apprentice at a major brokerage so why shouldn't you take the time to learn it if you are going to be managing your own money?
Unfortunately, everyone wants a simple answer and a quick solution - hedging is neither. Much the way you may have heard that diet and exercise can keep you healthy, hedging and balancing your portfolio can keep your finances healthy as well.
Both take hard work and determination over a great deal of time - something not everyone is prepared to do, unfortunately.
4 Inflation Hedges for 2011 [View article]
Step 1 - We want to hedge against inflation.
Step 2 - We decide to use XLE as un upside hedge to our $10K annual energy bill.
Step 3 - We want to offset an 8% rise in energy prices between now and 2012.
To buy XLE straight out, hoping to make $800 on an 8% rise in the stock, I would need to buy 200 shares for $13,400. If XLE were to fall 10%, I would lose $1,340. If XLE were to fall 20%, I would lose $2,680 and if XLE were to fall 30%, I would lose $3,020.
That trade would be net neutral on the downside to my annual energy spending so I am effectively locking in $10K of spending, laying out $13,400 in cash ($6,700 in ordinary margin) to offset $800 in rising oil prices.
My original suggestion was to sell 1 2013 $50 put for $4, collecting $400 and buying 2 2012 $55/60 bull call spreads for $2.6 ($520). That's $120 out of pocket, perhaps $2,500 in margin and you make $880 EVEN IF XLE falls 10% and you don't lose more than $120 until XLE is down 30%.
Maybe it's just me but I think it's a better play. This is not that complicated and people reading this should not be scared away from options or hedging - my goal is to enlighten the average investor and open this world up to them. It's a very powerful and very underutilized tool but, like many powerful tools - it needs to be handled properly.
As someone else pointed out, prices change every day and positions change constantly - it's not enough just to jump on a position but you have to learn how to manage them over time. For instance, today the VIX picked up a little so we found a few shorts to sell. When the VIX is lower, we're more inclined to buy puts.
4 Inflation Hedges for 2011 [View article]
We often trade longer time periods for lower strikes if it's margin efficient. Portfolio margin usually assumes a 20% move in the stock and once you get above or below that zone, your margin requirements get very low, which turns this into a very attractive trade for margin accounts.
Obviously, if you don't have a leveraged margin account, you should stick to "cheaper" plays like the XLF or even just simply buy a bull call spread that pays well like the XLE 2013 $66/70 bull call spread at $2, which pays 100% if XLE gains 5% and holds it through Jan 2013 - no margin just a straight 100% play to hedge some upside. Those are easy and can be found on hundreds of option picking sites - we like to go a little deeper when looking for opportunities.
So call it what you will but let's say you want to put $400 into that trade 2 spreads. That offsets $400 of increased energy costs but, if XLE flatlines or goes down 10%, you lose $400.
If however, you sell the 2013 $50 puts for $400, you are in the same $400 bull call spread but now you have decided that IF XLE falls from $67 all the way to $50, you will be willing to buy 100 contracts at net $46.
Now we take that $400 from the sold contracts and that ups your net entry on XLE to $50, which is still 30% below the current price. If you don't want to be long on the energy sector in 2013 with oil around $60 - walk away from this side of the trade!
If you do think that owning $5,000 worth of XLE at $50 is a good long-term use of your funds, then take the $400 for agreeing to buy it and use it to buy 2 call contracts. If XLE goes to $70, your consolation prize for not owning 100 shares at $50 is to get paid $4 for 200 shares of the spread ($800). Last I heard, even making $800 on $5,000 is pretty good money but nobody holds $5K in margin unless they are in an IRA so it's $2,500 - $500 depending on the type of margin account you have.
Even more importantly, look at your profit window. You have a $0 cost basis UNLESS XLE falls below $50. Since the idea was to hedge $10K of annual fuel purchases, even at $33 (50% off) if your fuel costs dropped $5K then you would only lose $1,700 on the short puts and, if that ratio stayed in place, you would never lose money to the downside. So what is risk? Risk depends very much on what you are protecting.
As I said, a lot of these strategies are counter-intuitive and have to be learned just like any profession is learned. It takes time and practice and you need to develop different ways of looking at your portfolio as well as your life and goals so you can set a path towards what you really need to achieve in your long-term planning.
PS - we just got off the Qs and are very tempted to go with SQQQ at $30.50 here - of course we're using options and selling short puts but just the basic ETF has a good chance of bouncing here and $30 is a nice, obvious stop-loss.
4 Inflation Hedges for 2011 [View article]
Also, as I mentioned in last week's S&P trade idea, if you have a Portfolio Margin account - there is a world of difference in what you put aside. I thought I was being clear saying that you are, in the XLE example, COMMITTING to buiying $5,000 worth of XLE at $50 (100 shares from one option contract). Whether that commitment costs you $5,000 in an IRA or $2,500 in ordinary margin or $505, as it does on my TOS margin screen is something that very much depends on your individual account.
Options trading is not a one size fits all exercise we teach different strategies for different types of accounts and different trading goals - can't possibly cover what amounts to a year of course-work in every 3-page post unfortunately but if I refer to our educational materials or training articles I get accused of trying to sell my service (heaven forbid!) so there's no way to make 50,000 people at SA happy, is there?
For a while I told them not to pick up my weekend articles to Members because we do touch on fairly advanced issues that require a bit more than a casual familiarity with risk management but SA cut the part where I mentioned that our service is all about helping people learn how to manage and adjust these trades over time so what can I do?
Anyway, if you want to learn option basics, you don't have to give us money. Market Tamer is an excellent service that specializes in teaching option strategies and they have a 14-day free trial and then just $147 a month. If you sign up you get a free copy of the same book that we give to Members on our own site so, if you want to learn more about basic options trading - try them at bit.ly/gQjaui
Hope that helps,
- Phil
4 Inflation Hedges for 2011 [View article]
Happy Holidays!
- Phil
4 Inflation Hedges for 2011 [View article]
That's also why we spend months and years teaching people how to hedge their portfolios - it's not the kind of thing you can get a "cheat-sheet" on.
Hedging is a whole other mindset for investors that needs to be practiced over time and learning how to do it properly is as real a course of study as any pursuit you will go for in college. It's a shame they don't teach this in business school but it's the first course you get when you apprentice at a major brokerage so why shouldn't you take the time to learn it if you are going to be managing your own money?
Unfortunately, everyone wants a simple answer and a quick solution - hedging is neither. Much the way you may have heard that diet and exercise can keep you healthy, hedging and balancing your portfolio can keep your finances healthy as well.
Both take hard work and determination over a great deal of time - something not everyone is prepared to do, unfortunately.