I hope you get everything you want this holiday season and, most importantly, I hope you have time to spend with your family. I love waiting for my kids to wake up on Christmas morning to come out of their rooms so I can videotape (gosh I’m old, there’s no tape anymore) them in those first moments of Christmas morning – how can I not be of good cheer anticipating that?
I have something I can give you for the holidays as well. Not peace on Earth but perhaps peace of mind heading into the New Year – a way to help insure some future prosperity with a few inflation-fighting stock picks that can brighten up your portfolio, which also can be used to help balance your home’s budget against unexpected cost increases.
This isn’t an options seminar or one about risk or leverage – these are just a few practical ideas you can use to hedge against inflation as it may affect your everyday life using basic industry ETFs and some simple hedging strategies to give you an opportunity to stay ahead of the markets if they keep going higher.
We haven’t felt the need for inflation hedges since 2011 as the Fed has kept us in a somewhat DEflationary cycle but our 2011 hedges were good for 300-600% returns and we’re simply going to repeat the same, simple concepts here to set up good, rational hedges against inflation to insure a financially healthy and happy 2016:
Idea #1 – Hedging for Home Price Inflation
Let’s say you have $40,000 put aside for a deposit on a home but you’re not sure it’s the right time to buy. On the other hand, let’s say you are worried that home prices will take off again (I doubt this but you never know). XHB is the homebuilder’s ETF, currently at $34.49 and they bottomed out at $31.62 in August and still well off the highs for the year of $39 right before the flash crash.
You can sell 20 contracts of the XHB 2018 $28 puts for $2.25 each ($4,500) and that obligates you to buy 2,000 shares of XHB at $28 (16% off the current price) and you can use that money to buy 20 2017 $28/33 bull call spreads for $3.50 ($7,000) and that’s net $2,500 out of pocket and you have 20 $5 contracts that pay back $10,000 if XHB simply stays flat through 2016. These bull call spreads, however, do not pay off early – the ETF needs to be above $33 at Jan 2017 options expiration day (the 20th).
So you are putting up $2,500 in cash and the margin requirement on the sale will be roughly $5,600 in an ordinary margin account. What have we accomplished? Well, if XHB goes up, your $2,500 becomes $10,000, adding $7,500 (300% gain on cash) to your $40,000 deposit, that should keep you up with up to a 20% jump in home prices but, if they go up that fast, getting a deposit will be the least of your problems!
On the risk side. We certainly don’t expect XHB to go to zero but let’s say it falls to $20 (1/3). Well, you are obligated to own 2,000 shares at $28 ($56,000) and you would have lost $8 per share, so $16,000 is your risk there but I would put it to you that, if we have a crash of that magnitude again, you are better off losing that $16,000 than if you had bought a home for $400,000 and had it drop 20% on you ($80,000) or even 10% ($40,000) and again, that’s a very extreme example and you are not locked into the trade, you can get out when the loss is $5,000, for example, keeping 87.5% of your deposit and feeling good about your decision to wait out an uncertain housing market.
That’s what hedging is, it gives you a cushion that can prevent things from getting away from you. For example, you can hedge this hedge by buying 20 2017 $28 puts for $1.20 ($2,400) and you cap your downside at $12 (the $16,000 loss) but you raise your outlay to $4,900 and lower your reward potential to a still respectable $5,100 (104%) – just an example of a way to control the downside and you can trigger a cover like that only if XHB fails to hold, for example $25. You can actually work these swings to your advantage by adjusting the trade as the stock moves through a channel but, for the sake of simplicity – we’re just discussing passive risk management examples. The idea is to reduce your risk of waiting – that lets you sit back and make an intelligent, well-timed decision without worrying that the market is getting away from you. Unlike CDs or Bonds, there is no penalty for an early withdrawal from a hedge, other than the bid/ask spread you may pay if you do it very quickly.
Idea #2 – Hedging for Fuel Inflation
Gasoline prices have dropped drastically this year and, if you are the average family, you buy about 1,000 gallons of gas per year ($2,000) and spend another $1,500 heating your home. That’s $3,500 a year spent on energy and it’s already down over $1,000 from last year – we might want to lock that in!
XLE is the ETF for the energy market and it’s currently trading at $61.57. If you want to guard against a $1,500 increase in the price of fuel next year, you can, very simply buy 3 Jan 2017 $60/65 bull call spreads for $2.35 ($705) and offset that cost with the sale of 2 2018 $40 puts for $2.50 ($500) for a total cash outlay of $205. If XLE simply hits $65 (up 5%) into Jan of next year, you make $1,295 (631% on the cash).
We can assume any increase in fuel prices over the year will push them higher and XLE has pretty much held $60 since 2010, the last time oil was below $50 that August, so this is a very nice mechanism for hedging 20% of your fuel cost. What’s nice about this is oil can fall and you’ll save money on your fuel and, as long as XLE doesn’t fall more than 35% by 2018 – the trade only costs your $220 cash outlay and you should save far more than that on lower energy prices (assuming that relationship is maintained, of course). Below 35%, you get assigned 200 shares of XLE at $40 in 2018 and that’s a price that’s held up very well since 2005, when oil was under $40. So a risk of owning $8,000 worth of the Energy Spider, which puts you bullish on oil at $40 – which will always make a another nice long-term general hedge against inflation.
Now our Members at Phil’s Stock World know they can roll those puts or convert those put assignments into buy/writes or do a dozen other things to mitigate the losses – as I said, these are really basic examples of how anyone can hedge their