Archive for August, 2011

Collar your gold to protect profits

Tuesday, August 30th, 2011

Tags: equity collar, hedging techniques

Gold has been in non-stop rally mode since October of 2008, but after advancing so far (over 150%) so fast, it’s looking a little tired…but has it run out of steam? Considering that the status of the world debt situation along with our own debt problems are far from being resolved, gold bugs have an excellent reason to keep holding the precious metal. But volatility has been coming out of the market and if it continues to drop, so might the price of Midas metal.

So what’s a gold-holder to do? Is there a way of protecting profits while still being able to participate in any further upside?

The answer is “yes” to both questions. The solution that will be presented in this article involves stock options; if you have no options trading experience, either get someone who does to assist you or use another insurance technique such as a simple trailing stop-loss.

What is a collar?
A collar is a cost-effective way to protect an equity position using options. Those with large positions in a single issue, such as corporate CEOs, typically use collars to protect their holdings.

The concept is straightforward: you buy a put with a strike price near the current price of your stock and you sell a call (usually with the same expiration date) to offset the price of the put. This offers you unlimited downside protection (less the difference between the strike price of the put and the stock price) but the sale of the call does limit your upside gains. After a long rally, however, many feel that it’s more important to protect gains than it is to wring more profit out of the trade.

Your choice of collar depends upon your risk tolerance as well as how much insurance you think you’ll need. Before we consider a couple of cases, let’s first determine appropriate strike prices.

Support/resistance levels in the GLD
Selection of appropriate strike prices for our gold collar is best done by looking at its support/resistance levels. Since one of the most popular ways of holding gold is via the GLD, the SPDR gold ETF, we’ll be looking at its chart to determine strike prices.

The GLD has topped out at $185 and has minor support/resistance at the 175 and 165 levels. (Major support levels are at 155 and 145.)

Protect profits with a tight collar
For those of you who have recently bought into gold, protecting yourself from a big loss is probably more important than maximizing your gains. In this case, you’ll want a tight-fitting collar. With the GLD closing the day at $179.10 (at the time of this writing), you could buy the September 179 put for $4.75 and sell the September 185 call for $2.50 for a total net debit of $2.25.

The good news is that you’re immediately protected against any loss while still retaining $6 in upside potential. At September expiration, you’ll realize a gain if the GLD is trading either over $181.35 ($179.10 + $2.25) or under $176.85 ($179.10 – $2.25). If the GLD is trading between $179 and $181.35, you’ll lose the entire cost of your insurance. Considering the recent increased volatility in gold, the chances of it landing in such a tight range in three weeks are pretty slim.

Increase profit potential with a loose collar
For those who have already made a substantial profit on their position, they can try a looser collar. A 165 put/190 call collar offers a lot of upside legroom while protecting against a major price plunge. Using September options, the total cost of this position is $0.77 for the put and $1.44 for the call, giving a net credit of $0.67. In this example, you’re actually getting paid to purchase insurance but in exchange for that, you’ve given up $14.10 of protection. (In options, there’s no such thing as a free lunch unless you’re the market-maker.)

Collar variations 
The good thing about using options as a hedge is that you can choose your own risk/reward scenario; the bad thing about using them is that choosing the right scenario can be confusing, even for seasoned options traders. Here are a few variations on the standard collar (September expirations are assumed in the calculations):

1. Laddering the strikes. For example, say you have a nice profit but don’t want to risk giving up a good chunk of it. In this case, you could buy a half put position at the 175 strike for $2.94 and the other half at a lower strike, say 165 for $0.77. Your total cost for the put side of the collar would then be $3.71 which is a savings of $1.04 over the 179 put given in the first example above.
2. Legging into the position. The term “legging” means entering into one side of the collar at one time and the other side at a later date. If you’re worried that gold may drop at any minute, then buy a put as soon as possible and wait until it rallies before selling your intended call. You’ll be getting a higher price for it which will lower your total position cost—you could even turn the collar into a net credit!
3. Using different expiration dates. When using collars, it makes sense to buy a put with a longer expiration date and selling front-month calls along the way, especially if you buy the put during a period of consolidation. You can then wait until gold begins moving back up before selling the call.

Although the GLD has a very rich options field, some strikes are more liquid than others. In general, strikes at the $5 and $10 levels have the greatest open interest (this is true for most stocks), and the greater the open interest, the faster your trade will execute, quite often at a more advantageous price.

With the huge run-up in gold, it just makes sense to protect profits. Using a collar is one way to do it. If you elect to try this method, I hope you will consider some of the variations given above.

Surviving Market Crashes

Tuesday, August 23rd, 2011

Introduction: Uncertain times makes investors jittery which can lead to bad investing decisions

Global and domestic debt concerns are making economic markets extremely volatile and investors are scared. After being beaten up by the bursting of the bubble in 2000, the subprime mortgage crisis in 2007, and the global debt and recession fear crisis now playing out, investors are justifiably fearful about placing their hard-earned coin into companies that may not be around in a couple of years, and many are fearful of losing their nest eggs.

They are facing complex and confusing economic information and are at a loss over how their portfolios should be properly invested. Should they buy gold? Should they divest their stock holdings and use the cash to stuff their mattresses? Will the market turn around soon and if it does, will they be too afraid to enter and miss out (perhaps again) on the ensuing rally?

Investors today have so many questions they can’t answer and many have just given up. But do not fear, help is here! There is a way to stay in the game and still get a good night’s sleep. We’ll show you how.

Asset allocation according to Modern Portfolio Theory: The pros & cons

Many wealth managers design portfolios built upon the concepts of Modern Portfolio Theory (MPT). We’ve discussed MPT many times before, but for those unfamiliar with it, it is a Nobel prize winning mathematical model which tells you how to best allocate your funds among various asset classes while minimizing risk.

Although MPT has revolutionized portfolio management, it is not without limitations. One of the precepts of MPT is that portfolios must always have funds distributed among the various asset classes, in good times and in bad. It is this concept that can lead to large portfolio losses during market corrections—losses that can take many years, even decades, to make up.

How this MPT limitation can be minimized

Realizing the risk of loss during downturns, portfolio managers have sought to downplay the MPT approach by offering their own managed services. It seems that each manager has his or her own approach towards curtailing losses and, typically, the approach is labeled as “proprietary” thus making it opaque to the investor as to how allocations are determined and exactly what components make up each asset class. On top of that, firms offering broad asset class diversification products typically charge a hefty load and/or management fee for the privilege of not telling you how your money is being managed.

When a manager claims that her allocation scheme is proprietary, I have to think that by “proprietary” she means “subjective,” because if her model was completely quantitative, she would say so—what’s there to hide? By contrast, we have created a completely quantitative modification to MPT that will save your portfolio from market crashes.

Market timing meets MPT

We’ve spent a lot of time and effort in developing an effective market timing model that, when combined with MPT, not only offers you higher overall returns at substantially lower risk but saves your portfolio from the devastation of market crashes. The beauty of this approach is that you need only rebalance your portfolio at most once per month. [For more information on how our product, the SMC Analyzer, works and how it can save your nest egg, click here.]

Although we use complex mathematics to determine asset allocations, the theory behind the approach is simple. We apply an indicator that is re-optimized every month for each asset class. When the indicator is positive, we allocate funds to that asset class according to what MPT proscribes. When the indicator turns negative, we take the funds that MPT would ascribe to that class and put it into the most risk-free asset class, typically T-bills (or an insured money market). For this article, we will call our Modified MPT model MMPT for short.

How market timing saved the day

Let’s see how two portfolios, one constructed using the traditional MPT model and one constructed using our market timing model, with the same return objective would have fared over the market crashes from the bursting of the bubble in 2000 through the current debt and recession fear debacle. Before we do that, though, let’s take a look at the chart of the S&P 500 which shows that the index lost 50% of its value from 2000 to 2002 ( bubble), 57% from 2007 to 2009 (subprime mortgage mess), and 20% (global debt debacle) so far this year (as of this writing).

Monthly chart of the S&P 500

Click to Enlarge

(Click to Enlarge)

Our two portfolios are composed of the same traditional nine asset classes shown below. We are also assuming a target required compounded annual return of 10% which is neither ultra-conservative nor highly speculative. The only difference between them is one enjoys the benefits of market timing, the MMPT portfolio, while the other does not.

    The nine traditional asset classes used in this analysis

  1. Large-cap U.S. Stocks (S&P 500)
  2. Small U.S. Stocks (Russell 2000, etc.)
  3. Long-Term Corporate Bonds
  4. Long-Term Government Bonds
  5. Intermediate-Term Government Bonds
  6. 30-day U.S. Treasury Bills
  7. Real Estate Investment Trusts (REITs)
  8. International Stocks
  9. International Bonds

Both were rebalanced following updated allocations provided each month. Returns from the beginning of 2000 to the end of this July are plotted against each other in the figure below. (The MMPT portfolio returns and stats are given in green; the classic model is shown in magenta.).

Comparison of Portfolio Returns & Risks for the Classic & Market-timing models

Click to Enlarge

(Click to Enlarge)


The results show an astounding difference in both returns and risk. The market-timing (MMPT) portfolio was not only able to make its required 10% return but it beat it while the classic model could only return a measly 2.5%, hardly better than the average return of a money market. The one positive thing we can say about the classic portfolio is that it was able to beat (barely) the compounded return of the S&P 500 during the same time period. (Click here to see how the same investment in the S&P 500 would have performed.)

More observations:

  • It took five years for the classic portfolio to break even after the devastation caused by the bursting of the bubble.
  • Four years after the beginning of the 2007 mortgage crisis, the classic portfolio still hasn’t been able to climb back to its pre-2007 high.
  • The risk as measured by the standard deviation (σ) of portfolio returns of holding the classic portfolio is more than double that of its market-timing counterpart. This fact alone should alarm you.


We have shown that the judicious application of an optimized market timing model to an MPT-constructed portfolio not only results in being able to attain the required return (at least up to a 10% compounded return) but at a substantially lower risk, too. Another great feature of the market timing model is that it does all this without the need for portfolio hedging or other costly risk-reduction techniques such as buying put options – the market timing model acts as its own hedge!

The few minutes a month that it takes to rebalance your portfolio is sufficient to protect your nest egg from the ravages of a market crash. Can your broker or money manager do the same for you?

A few notes on the article from the author

Gold was not included as a separate asset class in this analysis because most people do not hold it in significant proportion to the rest of their portfolio. But we might run the same analysis with it if there’s any reader interest. (We do include gold as an option on our SMC Analyzer monthly email report.)

We were going to go into detail on why the market-timing model outperforms the classic model during market crashes by showing the monthly allocation tables just before, during, and after each crash, but to do so would have made the article much more lengthy and involved. Again, if there’s reader interest, we can provide these data.

It will be interesting to see how the situation plays out during this current global debt/recession fear crisis. When the dust has settled, we’ll update this analysis. I hope your portfolio is mostly in cash or precious metals!

For further information on how you can protect your own portfolio, click here.

Pat Glenn contributed to this article.