Hedging Against A Sharp Decline Using Put Backspreads

I received an email from a subscriber a couple of weeks ago with a link to my September 2007 newsletter titled “Hedging Your bets”. His email indicated that it might be time for a part deux. He is seeing a number of warning signs that I am as well. The big rush in IPO filings, the insider sell/buy ratio rocketing eight weeks ago to 186.8 right before the recent decline in the major indexes, bubble like valuations for some stocks that have long been a favorite of momentum investors, structural debt issues faced by PIIGS (Portugal, Ireland, Italy, Greece and Spain), a drop in existing home purchases and an increase in the unemployment rate just to name a few.

Warnings signs and negative news are part and parcel of the investing landscape and the market likes to climb a wall of worry. At some point the market will summit that wall and if it is overextended, it will revert to the mean. In simpler words, “what goes up, must come down”. In fact, as homeowners in the recent real estate bubble and speculators in the internet bubble came to find out, reversion to the mean does not simply imply that prices revert back to the long-term mean trend line but they often shoot well below that mean. This special report is dedicated to a hedging strategy that is specifically tailored to profiting from a sharp drop in individual stocks. I looked at over 60 years of S&P 500 data and generated some price variance graphs to see if this strategy could be applied to indexes but it turns out that it lends itself best to individual stocks.

Source: Robert Shiller’s Online Data

Hedging Strategies:

Investors use several strategies to protect themselves or even profit from a sharp pullback at the start of a new bear market. Often the best strategy for individual investors is to increase the cash allocation of their portfolio. This not only allows you to sidestep part of the collapse but also leaves you with cash on hand when there is blood in the streets and bargains abound. Timing is very important with this strategy and if you are early, you could easily underperform the market for an extended period of time.

Other strategies include,

1. Building a long/short portfolio. The 130/30 strategy was very popular amongst  hedge funds where you had 130% of the portfolio invested on the long side and 30% of the portfolio in short stocks. The strategy lost favor following the sharp market rally from the 2009 lows.

2. Buying put options on stocks. You could purchase put options on stocks you own or on stocks that you consider highly speculative (naked puts). Buying puts is essentially insurance and like all insurance you end up paying for the protection. This can hamper portfolio returns in a steadily rising market and requires a lot of discipline.

3. Buying out of money index puts. This strategy is similar to the previous one but could cost less and allows you to bet on a large move by the market without having to cherry pick individual stocks.  If you feel small cap stocks are likely to take the biggest hit in the next bear, you could buy out-of-money puts on the Russell 2000 index.

4. Inverse ETFs, double inverse ETFs, triple inverse ETFs. The list goes on. The advantage of an inverse ETFs is that you can get portfolio protection in a retirement account. The disadvantages of double and triple inverse ETFs related to tracking errors and high volatility have been discussed widely in the financial media and it would be best to avoid them.

Beyond maintaining a diversified portfolio (I usually have between 25 to 30 positions at any time between my long-term and short-term portfolios), I have used each of the strategies mentioned above over the last few years.

Unless you were short the for-profit education sector or Chinese reverse merger stocks, the last two years have been very challenging for most people who have tried to use one of the strategies outlined above. I have personally used each of the strategies outlined above and paid for the insurance.

The Challenge of Shorting Momentum Stocks:

Experienced traders will often tell you that if you value your sanity it is best to stay away from shorting momentum stocks. The market can stay irrational longer than you can stay solvent. If Research in Motion (RIMM) appeared overvalued at $66 in June 2007, there was nothing to stop it from doubling again to over $133 in a span of less than five months. The parade of analysts falling over themselves to upgrade the stock in late 2007 was amusing to watch especially in light of the very successful release of the iPhone in June 2007. Both revenue and earnings were growing rapidly and investors continued to bid the stock higher without giving a hoot about the reversion to mean principle. The stock eventually peaked at a little over $147 in June 2008.

We know how that story turned out. Six analysts downgraded the stock on June 17, 2011 and the stock hit a low of $25.89 last week. Very few people have both the fortitude and the deep pockets required to ride out a long-term short position. The price of being wrong and sticking with a losing short position can also be steep.

For some time now, I have been fascinated by this challenge of shorting extremely overvalued momentum stocks. They could potentially present a good hedge for a long portfolio because they are also likely to decline the most when the market finally cracks. If picking undervalued stocks and waiting for the market to recognize their full value has been shown to work, why is to so hard to short stocks that are selling for over 50 times free cash flow or 10 times sales or (you can plug your favored valuation metric here).

I finally found the answer while reading the book Stock Market Wizards by Jack D. Schwager. One of the “wizards” interviewed in the book described a strategy called put backspreads. The strategy involves the sale of a near-the-money put option on a stock and then using the premium generated from this sale to purchase a larger quantity of out-of-money put options.

For example, selling the $145 July 2011 put option on Salesforce.com (CRM) would generate roughly $5.65 in premium. Using this premium, you can then turn around and buy two $135 July 2011 put options for $1.88 and pocket the extra $1.89 per contract. There are four outcomes to this position,

1. The stock does nothing upon expiration. This means you pocket the difference between the premium collected for the $145 put you sold and the purchase of the two $135 puts.

2. The stock goes up upon expiration. You once again pocket the difference between the premium collected and the premium paid for the purchased puts.

3. The stock declines a little. You end up with a loss, which would be limited to the difference or spread in the strike price of the options purchased and sold. In this case the maximum loss would be limited to $10 per share or $1,000 for each contract sold (contracts are 100 shares each).

4. The stock declines precipitously. You could make a lot of money based on the magnitude of decline. Ideally you want the stock to decline at least 15% or more to make money on this strategy but this depends a lot on the spread between the puts sold and the purchased puts. Your break-even point in this case is $126.89 as discussed in the next section below.

Three out of these four outcomes would result in a positive return. Essentially you are the “house” in this casino.

The best thing I like about this strategy is that you not only avoid having to constantly pay the price of insurance but also limit your losses unlike regular short positions. This is particularly attractive to me as one of my weaknesses is the inability to take a loss quickly.

Calculating the Breakeven Point:

The break even point can be calculated using the following formula as discussed in the OptionsExpress article I linked to above.

Downside Breakeven = Long strike price – [(Long strike – short strike) * # of short contracts] + net credit/100 (or – net debit)

Downside Breakeven = 135 – [(135 – 145) * 1] + 189/100 (the $189 credit is the $1.89 per contract you had left over after purchasing the two $135 contracts)

Downside Breakeven = $126.89 (this is 11.29% below the current price of $143.04 of CRM)

Finding the Ideal Stocks for this Strategy:

So how does one go about finding the ideal stocks that would lend themselves to this strategy? Here are five things that I personally look for,

1. Run a screen that finds stocks that are trading at extremely valuations and or look through the list of stocks making new 52 week highs. A simple screen I ran for companies that trade for more than 50 times free cash flow and more than 10 times sales is given below.

2. Look for stocks with aggressive insider selling. I had put back spreads on networking company Acme Packet (APKT) and Buenos Aires based online payments company Mercadolibre (MELI) last month following consistent insider selling at both companies. Those positions paid off very well last week. Both companies also met my high valuation/high momentum criteria. Despite a sharp decline over the last month, Acme Packet is still trading at over 95 times free cash flow and 48 times EBITDA.

3. Look for stocks with high volatility. This will help you get a good premium for the puts you are selling. If the premium collected is high enough, you may have some money left over even after buying twice the number of out-of-money puts. Obviously this also depends on the spread between the puts. I use the IVolatility.com website to determine the volatility of the stocks I am considering. You can use this link to view the volatility for Netflix (NFLX), which is 38.02% as I write this report. Ideally I am only considering stocks with volatility above 30%.

4. Watch out for company specific events that may occur during the period you will hold the spread. For example I was considering establishing a put back spread position on Lululemon Athletica (LULU). The stock meets several of my criteria including selling for 121 times free cash flow, trading close to its 52 week high, significant insider selling and a volatility reading of 44.85%. However I noticed that the company plans to split its stock 2:1 on July 12 (July 6 on the Toronto Stock Exchange). This event occurs before the July 2011 options expire and hence gave me pause as stocks of companies undergoing splits often tend to appreciate around the split date. Sometimes a company specific event may actually be helpful. For example an earnings release date before your options expire may be helpful as the stock price is more likely to react sharply following an earnings release.

5. Finally look for stocks that have a healthy volume of options activity. I had to hold my position in MELI past expiration and ended up net short the stock for a few hours as the bid/ask spread on MELI options around expiration was very large and I would have forfeited a significant chunk of my profit if I had tried to close the position before expiration.

Stocks Trading at More Than 50 Times Free Cash Flow and 10 Times Sales

It is interesting to find several Software-as-a-Service (SaaS) companies like Salesforce.com (CRM), NetSuite (N) and SuccessFactors (SFSF) on this list. Please note that SaaS providers may have large deferred sales and hence may look expensive on a Price/Sales basis. The only cleanup I did of the results generated by this screen was to remove several closed-end funds.

A Word of Warning:

A final word of warning. This strategy is still a directional bet on the market and while your loss is limited, you may still end of paying for this enhanced insurance policy. Over the years I have come to realize that every strategy has its ups and downs and sticking with a proven strategy despite a temporary setback is crucial to long-term investing success. I plan on putting no more than 5% of my portfolio at risk with this strategy.

Voluntary Disclosure: I have a put backspread position on CRM, I have a short position in OPEN and plan on initiating put backspread positions in NFLX and LULU in July.