Caveat Emptor: Buyer Beware on Shares of…

Louis BaseneseThe latest funds-flow data hint that investors are getting skittish.

Stock funds are under heavy selling pressure.

Meanwhile, bond funds are suddenly in favor.

Here’s a quick look under the hood…

  • First-quarter inflows into U.S. bond funds just hit their best levels since Q3 2012. More than $7 billion flowed into bond funds in the latest period
  • On the flip side, investors are exiting developed-market stock funds. Such funds just posted their biggest outflows since early in last year’s third quarter.

Boy, this news holds bearish implications for the stock market.

I asked my senior analyst, Martin Hutchinson, to make sure our readers are prepared for a correction.

Is your portfolio insured against a downturn?

Hutch’s full analysis is below…

Ahead of the tape,

Louis Basenese
Chief Investment Strategist, Wall Street Daily

Question: Martin, I want to take a break from our regular event-driven interviews and do something a little bit different. With the market a little bit toppy and some of Trump’s policies, I thought it might be prudent to cover how to protect ourselves against the downside. So let’s get into it a little bit. Are you up for it?

Martin Hutchinson: Sure. It’s a very interesting topic.

Question: Suppose our readers want to take a position against the market. There are prudent ways to do that — and then there are not so prudent ways to do that. If you don’t mind, let’s cover a few of those. Let’s start with the strategies that you would not endorse, Martin.

Martin Hutchinson: There are two strategies I wouldn’t endorse. The first is just selling the market short. In other words, you take a stock that you think is too high and then you short sell it.

For retail investors, that’s a very expensive strategy, because the brokers will charge you an arm and a leg. It also has the problem that your upside is limited. The stock can only go to zero, but your downside is infinite. That’s a thing that stops me sleeping at night, I have to say.

Question: Let’s recap that quickly for our listeners out there. You’re saying that the downside is unlimited when you’re short a position — whereas the upside is capped at 100%, because a stock can only go from its current price to zero.

Martin Hutchinson: That’s absolutely correct.

Question: It’s also true that you need a margin account. You have to operate on margin to do this, because in a short, aren’t you borrowing shares first and then buying them back later?

Martin Hutchinson: You’re borrowing shares and buying them back, and you can only do it on a few shares. That’s because you’ve got to be able to borrow them, and the brokers skin you an arm and a leg, particularly if you’re a relatively small retail investor. Institutions can do it more efficiently.

Question: So as far as shorting a stock, there are probably going to be some instances where it makes sense, but overall, it’s not for us. Let’s move on.

Martin Hutchinson: Overall, it’s not for us. The second thing I would caution against is selling call options on a stock. In other words, you give people the right to buy the stock off you at set price. That works fine unless the stock goes up — at which point you have to provide the stock.

Now, obviously, you can sell covered calls on stock that’s already in your portfolio. That’s a very sensible strategy in many respects.

But of course, you’re not really shorting the market then, because you still own the stocks. So you’re long the stocks even though you sold the call options on them.

Question: Let me recap that for us real quick. We don’t want to sell a call even though we’re going to get cash in our account right out of the gate. You’re saying selling a call is not the way to go. We’re going to get a nice cash deposit for doing so — but there may be some downstream impacts of that trade that you’re not too keen on.

Martin Hutchinson: That’s right. If you do own the shares, then you haven’t really gone short. And if you don’t own the shares, as Daniel Drew I think said once, “He who sells what isn’t his’n, must buy it back or go to prison.”

Question: And then the covered call is a prudent strategy, but it’s not particularly a bearish one.

Martin Hutchinson: That’s right, absolutely.

Question: What do you say we talk about the way to properly go against the market?

Martin Hutchinson: The best way to go against the market is buying put options, but not any old put options. You buy ones that, firstly, are long-dated and, secondly, are out of the money.

The reason that you want them long dated is because, quite often, you think the market is going to go down but you have no idea of timing. Therefore, you buy the longest possible put options to give you time to be right.

Then, the second thing is you buy them well out of the money, because you don’t want to pay too much for them.

Your downside risk with put options is the entire cost of the put option. But if the options are out of the money, that’s not necessarily a huge amount.

One stock we looked at is trading around $90. If you buy January 2019 puts at $75, that only costs you $5. So in that case, your downside is $5. But of course, the stock won’t just stop at $75. If it starts going down, it could go to $30 or $40. Your upside then would be $35 or $45.

So buying out-of-the-money put options, long dated, is a strategy that will make you many times your money if it goes right. And it’s not going to be too expensive if it goes wrong. Your only cost is the put options, which won’t be that expensive.

Question: What we’re really talking about here is the power of leverage, right? We’re not spending a lot to get into this trade, but we’re magnifying our gains on the way down.

Martin Hutchinson: Absolutely, and it means that you can protect your portfolio by buying put options. For example, on the S&P index, also out of the money, they are only a small fraction, maybe 3% or 4%, of the value of the portfolio. That’s a very useful strategy if you think a crash is coming but you don’t know when or how big.

Question: Fantastic, Martin. We should do more of these pieces. So this was “How to Go Against the Market,” by Martin Hutchinson. Thanks a lot, Martin.

Martin Hutchinson: Great pleasure…

Question: This is Wall Street Daily signing off.

Smart investing,

Martin Hutchinson

Martin Hutchinson
Senior Analyst, Wall Street Daily

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