A Hedging Strategy For Volatile Markets: To Buy, Or Not To Buy?

What to do: buy or sell? A dice with answer options.

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Investors are continually confronted with two fundamental questions when it comes to investing:

  1. What should I invest in? and

  2. Is it the right time to invest?

We are experiencing an unusual time as both the stock and bond markets are struggling with the answers. For instance, investing in energy stocks, like Exxon Mobil (XOM) seems to be right… but are they over-extended and due for a drop? Should one wait for the drop? … or … should one invest now and avoid missing an up move?

Now, I enjoy reading the articles in Seeking Alpha as much as anyone. Within many of those articles are useful and helpful information. Unfortunately, it is my sense that we get a little too much “buy this”. “back-up the truck”, “we’re at a bottom” and “the big crash is coming”. No article, no matter how ingeniously researched and written can ever really answer the two fundamental questions… “what?” and “when?”.

The reason they can’t answer lies not in the abstract of the market, but in the individual investor’s temperament, risk appetite, objectives, and portfolio makeup. What is good for the Goose is not, necessarily, good for the Gander. No one authoring an article (possibly not even the investor, themselves) has this level of information. Let me be perfectly clear… this “missing” information… personal and specific to each investor… is as much or even more important than universal factors such as P/E Ratios, Bollinger Bands and Dividend rates.

So, I can’t answer these questions for the reader. But what I can do is teach “strategy”. And teaching “strategy” is what I’ve done for over a dozen years on SA.

Let me also say that I never recommend a strategy that I have not previously or currently employed. These strategies have been tested, time and time again, refined, over and over and are presented for the readers arsenal of ideas… ideas that the reader can use and employ when and if they choose.

Modified Collar Strategy

The strategy covered in this article I call the “modified collar”.

The “modified collar” is designed to fit a particular situation, not every situation. Parameters that must be present for its utilization consist of:

  1. A stock trading near all-time highs
  2. The stock is likely to see short or midterm advances, but could see a drop
  3. The investor likes the stock, wants to own it but is uncertain if now is the right time or they should wait for a pull-back
  4. The lower the Beta of the stock, the better
  5. A steady dividend stream is helpful
  6. Options are available and, importantly, bid/ask spreads are reasonable

Parameters that do not fit the “modified collar” include high beta stocks and stocks that are trading well off their highs.

In short, the “modified collar” can be seen as a technique to hedge additional purchases in an uncertain market and not try to repair a fallen angel.

The Objective:

  1. To allow purchase of the selected stock
  2. To allow some pre-determined upward gains
  3. To protect against a drop
  4. To “effectively” buy after a drop
  5. To collect dividends while waiting for the up/down move

Now, let me fill in some blanks by inserting my personal objectives in choosing the specifics that I will discuss later:

  1. I judge that energy has some room to run
  2. I judge that XOM is a safe, long-term investment
  3. As a retired individual, my objective is returns of around 10% coupled with capital preservation
  4. I judge that XOM is possibly 20% over-valued and once the tailwinds mitigate, a retracement is likely and I want to protect against a 20% drop

The Mechanics:

Well, first we must start with a discussion of Options, as the only way to meet these objectives is with them.

Here’s a chart (prepared by Fidelity) that show the option prices for XOM for June 2023. Let me start by saying that I choose a one-year (sometimes greater) expiration because I like to think of myself as a patient long term investor and I want to try and match the duration with the risk.

XOM calls and puts

XOM Calls and Puts (Fidelity Investments)

Please note the three high-lighted areas. Please keep in mind that these prices are as of the close on Friday, July 1st when XOM was trading at $87.55. Values may differ by the time it is published. That said, they all move in tandem and only an extreme move would make any difference.

On the call side, I’ve highlighted the June 2023 $95 call, the June 2023 87.5 put and the June 2023 $70 put.

Here’s the modified collar:

  1. Purchase an at-the-money (ATM) put at strike 87.5
  2. Sell an out-the-money (OTM) call at strike 95

This completes a collar (buy put/sell call)

I modify the collar by:

3, Selling a deep-out-the-money (DOTM) put at strike 70

The purpose of the DOTM put is to reduce the overall net cost to approximately ZERO.

Here’s another chart, also prepared by Fidelity, that illustrates the three option trades.

Please look to the summary which illustrates the Bid/Ask/Mid prices. As you will see, ZERO is approachable.

Modified Collar

XOM Modified Collar (Fidelity Investments)

Results:

Well, of course, we don’t know the results because that’s the future. What we do know is the ranges of what can happen.

So, let’s dissect the range of possibilities:

XOM goes nowhere, landing in June 2023 at 87.55

  1. The puts and calls expire, worthless.
  2. The stock made/lost nothing
  3. Collect dividends around 4%

XOM goes up, but lands below $95

  1. The puts and calls expire, worthless
  2. The stock makes the profit above $87.55
  3. Collect dividends of about 4%

XOM goes above $95

  1. The puts expire worthless
  2. The stock is “called away” at a profit of $7.45, which is a profit of 8.5%
  3. Collect dividends of about 4%
  4. Total profit of about 12.5%

Let me digress a little. Any time I make 12.5% on a stock that I would, otherwise, have waited for a drop (never came)… I’ll take it and move on.

Let me also point out that if XOM rose so precipitously so that it is “called away” very early… one might not get all the dividends. But they get the 8.5% earlier and in almost any iteration realize a better than 12.5% APR. And they can sell what remains of the put-buy for even more return.

XOM falls, but lands above $70.

  1. The call-write and put-write expire worthless
  2. The stock loses the drop
  3. The put-buy (at 87.5) makes whatever the stock lost
  4. No, net, overall loss
  5. Collected dividends of about 4%.
  6. It is essential to recognize that if XOM dropped to, say $75, that is my net actual cost basis after accounting for the gain in the protective put. So, any drop up to $70 just represents a lower “effective” entry point.

XOM falls below $70

  1. The call write expires worthless
  2. The put-buy fully protects the stock drop, offsetting any loss
  3. The $70 put-write forces a buy-in at $70… a 20% drop from current levels.

Recap

So, what we have is collecting the dividends, with a possible gain of up to 12.5% (including dividends) and a forced buy in at $70 — only after a 20% drop. Any down move, above $70 is fully covered.

This meets my objectives of 10%+ potential return, with no risk above $70.

Now, on expiry, I can roll the position forward, hold, sell or buy more depending upon circumstances. If there was a drop, I need to decide whether or not it’s sufficient to just hold the stock “naked” of options… or to roll a similar or new strategy.

Variations:

I detailed the parameters that fit my objectives. Everyone is different and the modified collar lends itself to infinite variations.

For instance:

  1. One can allow more upside by setting the call-write to a higher strike, say $100. This generates a lesser credit which can be either taken as a cost item or financed by raising the put-write strike from $70 to $75.
  2. One can allow more downside protection “fiddling” with the strikes in the same manner.

Summary

What I’ve presented is a hedged approach that trades off some upside for protection on the downside. It is a technique that can be very successfully utilized with dividend paying stocks that are at or near their tops and the investor wants to enter on a drop, but is uncertain if the drop may be soon, distant or not at all… creating the classic dilemma of “when”.

Of course, we know from experience that most investors don’t actually enter stocks on a drop as fear sets in. So, this technique is valuable to those that earnestly want to take advantage of a drop but can enter any time and also enjoy some possible upside while collecting dividends waiting for the drop.

It is important to accept that it should be implemented on stocks near highs. For instance, it would have worked beautifully on AMZN, GOOG, AAPL or the like if instituted in January, but certainly not today. I leave it to the reader to find those stocks where it works. But the energy or material sectors have lots of them.

For those hoping to repair fallen angels… fret not… when I get the time for my next article, we’ll deal with that.

Housekeeping:

The modified collar may be interpreted as a straddle under IRC 1092 if it is deemed to substantially reduce possible loss. It is unclear whether or not Sec 1092 will apply. However, if it does apply, then any gain would need to be realized for tax purposes at the end of the year.

Additionally, instituting the option positions without buying additional stock, and, instead, using it to hedge an existing holding could trigger 1092 on the existing position. So adding the options to protect old, not new, purchases is problematic.

There is also a quirk in the tax law regarding dividends. The option positions would cause any dividends to lose “qualified dividend status” and be taxed as ordinary income. So, one must include that factor in their analysis.

Of course, these rules do not apply to IRAs and Roth, so it can be used as a hedge for old or new positions without complications in such accounts.

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