This year so far has been the worst run for equities markets since 2008 – and there’s more pain to come, if you believe the prevailing view on Wall Street. There’s simply not enough “blood in the streets,” according to the bears – an interesting take, as no one can provide clarity about why equities markets are falling (except for the obvious shift in investor sentiment).
There is conjecture to be sure. Slowing growth in China over the past year has resulted in more than US$1.3 trillion of capital outflows, some of which has found its way into the real estate markets in Vancouver and Toronto.
Competition within the Middle East for market share in oil has removed any notion that economics of supply and demand have a role to play in this march toward the abyss.
The Middle East oil producers are engaged in one-upmanship of the worst kind, intent on pounding enemies into submission, with the oil sledgehammer being the weapon of choice.
Certainly, we can blame some of the carnage on slowing economic growth in China. The trouble with this theory is that this situation is not new and is understandable. In short, the world’s second-largest economy is making the transition from being dependent on exports to being supported by strong domestic consumption.
Such transitions create dislocations, which can cause shock waves globally. However, the long-term strategy is rational and the playbook is recognizable. For China to achieve its goal, it needs a resilient middle class supported by a strong housing market and robust capital markets governed by well thought-out rules. China’s strategy is the right move; it simply takes time.
The oil question is more worrisome. Despite the many benefits that come from lower prices at the gas pump, the U.S. oilpatch is leveraged. With the Middle East striving to clarify its pecking order, that fight is driving U.S. oil companies out of business – and that could impact the U.S. junk bond market gravely.
Some of the more vocal bears compare the current situation to the one leading up to the 2008-09 global financial crisis. Although I don’t believe that to be the case, the theory does explain the poor performance of financial stocks, currently the second-worst performing sector – behind energy – in the S&P 500 composite index.
What we know is that global equities markets are in a serious correction. The U.S. stock market simply is the best-looking house on a very poor street. We know that bonds are rallying in a flight to quality, and options premiums have moved sharply higher.
With that in mind, you would be well served to evaluate the potential downside, using whatever tools are available – and where possible, hedge with options.
To that point, consider my situation: I happen to like Bank of America (symbol: BAC; recently priced at US$14.50 a share) and have allocated slightly less than 4% of my assets to the stock. My long-term assessment remains positive because any serious gains in the U.S. economy will depend on the health of the U.S. consumer. BAC is the lead financial services institution in terms of personal deposits and the second-largest – behind Wells Fargo & Co. – in mortgage originations, and does not have significant exposure to the U.S. oilpatch. But this column is not about my long-term thesis; rather, this is about the current sell-off and the impact that it has on my clients’ accounts.
I decided to sell some covered calls against 60% of the outstanding BAC shares. Specifically, I sold the BAC May 15 calls and the BAC August 16 calls for approximately US95¢ a share. This means if I am forced to sell some of the shares, I will receive either US$15.95 (based on the May US 15 strike price plus the US95¢ premium options) or US$16.95 (based on the August US$16 strike price and the US95¢ premium).
The sale of the calls reduced my downside exposure to US$14.05 a share on 60% of my outstanding BAC position. That’s my short-term hedge, which I believe is appropriate because the carnage we’re witnessing is not likely to abate until the second half of the year.
The value with this strategy is that I am selling covered calls because premiums have expanded, reflecting the market’s perception of risk. Stated another way, I am selling expensive options.
Of course, this position is not static. I may roll the covered calls up or down, depending on market conditions. Should markets stabilize, options premiums will contract and there may be an opportunity to close out some positions at a profit. Thus, I am using my covered-call strategy as a hedge and not as a tool to set a target price to sell the shares.
Other strategies you might consider is buying puts for insurance purposes. The problem with this strategy is that you are paying more for insurance because of the higher premiums. The alternative is to employ put spreads in which you hedge to a specific price target in the market. Using a spread takes volatility off the table because you are buying and selling expensive options.
Suppose that you believe the S&P 500 may decline by another 10%. If we attach that view to, say, the S&P 500 depositary receipts (symbol: SPY; recently priced at US$187.50 a share), that would imply downside risk to US$170 (i.e., 1,700 on the S&P 500).
As a hedge, you could purchase the SPY May 185 puts at US$7.30 and sell the SPY May 170 puts at US$3.50. The net cost for the trade is US$3.80 and the potential return, given the 10% correction, would be US$15 per contract, which is the difference between the 185 and 170 strike prices.
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