Sweet Redemption: How My China Put Strategy Worked To Perfection by Jake Huneycutt
Alas, it has taken several years, but I have my sweet redemption. My China put option strategy has worked to perfection in 2015. Unfortunately, however, I never got to see it through. I got sacked a year too early after I experienced a run about 10 months of underperformance.
The origins of the strategy go all the way back to 2010. It was that year that I first encountered one of the world’s most famous short-sellers: Jim Chanos. Chanos was appearing all over the media talking about the Chinese Asset Bubble. In the investment world, there’s a lot of hyperbole out there and you have to learn to ignore most of it. As it turns out, gold did not go to 10000, the US did not experience hyperinflation, and the Yuan has not replaced the Dollar as the world’s reserve currency. It would be easy to dismiss Chanos’ grand claim that China was Dubai times 1,000, as well. Yet, Chanos’ argument made a lot of sense.
I was a neophyte Portfolio Manager at the time. I had gotten my start by aggressively buying into the depressed markets of late 2008 and early 2009. In late 2008, I focused on buying into commodity producers. In early 2009, I shifted towards the REITs and was finding deep bargains in that sector. I ended 2009 up over 100% in my personal portfolio.
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After writing a series of articles on the REITs from early to mid 2009, I started managing a long / short portfolio for an ultra high net worth client in late 2009. In 2010, my portfolio was mostly focused on REITs and financials, but Chanos’ thesis on China intrigued me. My first six months went very well, before I had a period of underperformance during the Eurozone crisis. Much of it was driven by investments in small banks; a sector where I had underestimated the regulatory risks of Dodd-Frank; coupled with an overly aggressive FDIC.
In my first six months, I generated a return of 28.2% vs. the S&P return of 8.3%. Not a bad start to my career as a PM. In the next 12 months, I struggled much more, losing -2.0% versus an S&P performance of +14.9%. I was still ahead overall by about 100 to 200 bps, but it was a humbling period.
It was right after that I began another major period of outperformance in part driven by the China thesis. Over the course of 3 years, I implemented two separate put option strategies related to the Chinese Asset Bubble. The first was a big success. The second, I never got to see through, but with the market crash of the past few months, it’s clear that it would’ve been an even greater success.
The Commodity Short Strategy of 2011
I had remained intrigued by China in late 2010. I was new to the world of short-selling and had not yet grown very comfortable with it. My client introduced me to options trading in 2010 and I had slowly experimented with very small positions. I grew more comfortable over time.
Around April 2011 as commodity prices were surging, I put two and two together and decided that instead of directly shorting China, I would use a put option strategy. I was more comfortable with the idea of limited downside.
Moreover, instead of targeting China per se, I felt like the commodity producers were much stronger targets. I reasoned that even if China engineered the so-called “soft-landing” (a result I have always viewed as unlikely), that commodity producers would still see major reversions towards the mean, hitting their stock prices significantly.
I had great familiarity with the commodity space after buying in during the 2008 crash and thought that copper and silver prices were greatly inflated. Moreover, I thought the prices on rare earth minerals were out of the stratosphere and had nowhere to go but down.
Around April 2011, I decided to buy long-dated put options on several companies in that sphere. Copper producers Freeport McMoran (FCX) and Southern Copper (SCCO) were my two of my bigger focal points, but silver-related companies such as Pan American Silver (PAAS) and Silver Wheaton (SLW) were also included. I also bought put options on Stillwater Mining (SWC).
Yet, the most important prong of my strategy was the most difficult to implement. I bought deep out of the money put options on two rare earth mineral companies, Molycorp and Rare Element Resources (REE). These were my two highest confidence picks, as I felt that rare earth prices, which had surged anywhere from 500% – 3000% over the prior 3 years (depending on the particular mineral) were destined for a plunge within 18 months. This made rare earths perfect for a put option oriented strategy. Buying puts on those two companies proved to be a little trickier than expected and I had to slowly build the positions over a period of 4 to 6 weeks.
Since I was relatively new to the world of option trading, I decided to limit these positions to about 0.75% – 1.00% of the portfolio. I didn’t want to get carried away until I felt more comfortable with these sorts of strategies, but it ended up working out very well. In baseball terminology, I had hit solid doubles and triples on the copper, silver, and platinum portions of the portfolio (100% – 300% returns on the positions), but the rare earth puts were home runs, generating returns in the 500% – 1000% range in about six months time.
Interestingly, my portfolio still underperformed during those months as I had started buying into the homebuilders a few months earlier, and my homebuilder positions were getting hit hard. This was good news to me, however, because the builders were absolutely dirt cheap at that point, so I used the profits off the commodity puts to increase my stake in the US homebuilders, particularly Pulte Homes (PHM) and Toll Brothers (TOL).
The commodity put strategy coupled with my buys in the homebuilder, real estate, and the financial sectors would help fuel a major period of outperformance for me. From September 2011 through June 2013, I generated a 78.7% return compared to the S&P 500 gain of 31.8%.
The Delta Call Option Strategy
While I was “short” on China related themes the entire period from 2011 – 2014, it became less of a focal point in 2012 after commodity prices correctly significantly. The next big period in the China short theme doesn’t come till 2013.
Before I move forward into that, however, we should first take a bit of a detour to a completely unrelated Delta Airlines call option strategy in 2012. The Delta call option strategy was a failure for me, but should not have been. As such, I learned a valuable lesson from it and it influenced how I ended up implementing the second big stage of put option strategies related to the Chinese Asset Bubble.
You can see my basic thesis for Delta in an article titled, “Why Airline Profits Will Fatten Over the Next Decade.” In that article, I point out that there were several trends working in favor of the airlines in 2012. The most notable trends included (1) the Commodity Bust, (2) the North American Shale Boom, and (3) airline consolidation.
To play the thesis, I invested directly into Southwest Airlines (LUV) and JetBlue (JBLU). However, I saw Delta as having the greatest upside potential. For me, there was only one big issue: Delta’s pension plan. I had significant concerns about it even though I liked pretty much everything else the company was doing. The liabilities from that plan worried me enough so that I was reluctant to go long directly on the stock.
Yet, I reasoned, this was the perfect opportunity for an option oriented strategy. A long-dated call option strategy was better for limiting my downside on DAL, while giving me much higher upside potential.
I can’t remember the exact month that I initiated this strategy, but I’m going to guess sometime around January or February of 2012. At the time, the longest dated call options I could buy were for January 2013. I can’t remember the exact strike prices either, but I believe some were at $15 and others were at $17.50. All the options I bought were considerably out of the money as the stock likely traded somewhere in the range of $7 – $10 at the time.
I initiated a few small positions probably totaling about 0.2% of the portfolio. That seems incredibly tiny, but remember with these strategies, I’m generally expecting to either lose 100% or make 200% – 2000%. A 500% return on these positions would have added about 100 bps in performance to the portfolio, while a 1000% return would have added 200 bps; neither is an insignificant figure. More importantly, I didn’t want to bet the farm on what was, at best, an experimental strategy, so my downside was limited to 20 bps.
These DAL call option positions ended up being a bit frustrating. The worst possible result in my mind was that DAL’s stock price could rise significantly, but not enough to allow the options to profit. Indeed, if the stock price had fallen, that would’ve been a better result for me, because it would have made re-initiating the positions in late 2012 a no-brainer.
As it turned out, that worst-case scenario did play out. It was apparent in December 2012 that the options weren’t going to be winners, but the stock was rising enough to leave me conflicted. At option expiration in January, the stock was right around $14; close to the worst case scenario for my options.
One of my big maxims is that being “right” or “wrong” is irrelevant in investment. Risk and reward are what matter. This is a pretty classic example of that in action. I was absolutely “right” about Delta, but I wasn’t “right” enough in exactly the right time period to profit from it. Where I made my mistake was not re-upping the position in December 2012.
From early December 2012 to late January 2014, DAL’s stock rose from $11 to $31. That was exactly the type of huge jump I needed to make the strategy worked. Unfortunately, I implemented it one year too early and did not try it for a second go, mostly due to frustration.
Now, there is a legit case to be made that I made the right decision. At the very least, it’s far from a black and white scenario. Without the big market boom of 2013, it’s unlikely that DAL would’ve experienced such a huge jump. Nevertheless, I do regret not making a second attempt with DAL in December 2012, as I had briefly considered doing.
The failure of the DAL call option strategy is really no more than a minor footnote in my investment track record. I lost no more than 20 bps of performance from it in a year where I wildly outperformed the S&P by 1630 bps. It’s doubtful that any other human being who could’ve watched that portfolio would’ve even noticed this minor failure. But I noticed it. After the stellar run Delta had in 2013, it’s likely that I could’ve added 200 bps of performance in 2013 from a similar small position.
Yet, I took away a major lesson. The one issue with option strategies is that you can generally only buy 10 – 20 months into the future. As a long-term investor, this can be frustrating, because I know all too well that sometimes theses can take longer than expected to play out. Yet, a long-term options strategy is certainly do-able; it just requires persistence and discipline. I employed neither of those attributes with DAL in December 2012.
The China Put Option Strategy of 2013
This leads us back on the road to China. In 2011, the commodity short strategy had worked well. More importantly, I was spot-on about the homebuilding stocks and that ended up being a major driver of my portfolio returns in 2012 and early 2013. I focused less on short-selling and put options in 2012 than I had in 2011. However, in 2013 as the market continued to advance rapidly, I started to grow more concerned again.
By mid 2013, I was convinced that I had to do something to hedge significant risks in the market. While I was still intrigued a bit by shorting certain commodity oriented companies, I did not think a commodity shorting strategy had quite the upside that it did in 2011. Nevertheless, I re-established small short positions (no put options this time) on FCX and SCCO.
This time, however, I decided to focus more directly on China. I ended up buying long-dated put options on the iShares MSCI China ETF (FXI). This might have seemed like a lazy strategy, but given my limited selection, I thought it was a suitable vehicle. I was particularly happy about the fact that the ETF had about a 40% concentration in financials.
The only problem was that it was pretty clear to me that the bubble could drag on for awhile. I was doubly concerned by the fact that the US market was starting to look a bit overheated, as well. By mid 2013, I realized I was in for a rough ride. The deep bargains I had found abundant from 2009 – 2012 had all but disappeared. There were some reasonably priced stocks, but nothing like the REITs in 2009 or the homebuilders in 2011 that I thought would drive significant outperformance.
I was very familiar with some of the short-sellers of the late 90’s who were absolutely correct about the Tech Bubble, but still lost their shirts because they were too early. Julian Robertson, in particular, was one of the greatest investment managers of the 20th Century. He had bet against the Tech Bubble and this had led to a few years of underperformance. He eventually had to shut down his fund, Tiger Management, in March 2000, in spite of having one of the greatest long-term track records of all-time. This was right near the top of the market and a mere five months before its precipitous drop.
I knew the environment of 2013 was the worst possible environment for my sort of style. I also realized that a capital preservation strategy could be extremely profitable over the long-term. While I did initiate some direct shorts, I decided to focus on the long-dated put option contracts again. I was more confident this time as my experience with options had grown. I had great success in 2011 on the commodity puts, so I saw how these strategies could be highly beneficial to long-term performance. Due to my failure with the Delta call options, I also started to get a better sense of how I needed to manage these positions when they didn’t work out as quickly as I wanted them to.
I took a risk and decided to put about 1.5% – 2.5% of the portfolio in what was essentially a boom-bust strategy. I would buy long-dated put options on FXI and a few other securities that I believed would get hit in a China bust scenario. Over time, if the underlying securities continued to go up, I would keep gradually adding to these positions until the strategy worked out. As positions expired, I would also gradually re-add more.
If the market remained stable or continued moving upwards, I would likely lose 100% on these investments. This would be about a 200 bps annual drag on my portfolio performance every year until the strategy worked out. That was the downside and the major risk. However, this was a very manageable risk and ultimately, 200 bps of lost performance was not a disaster.
The upside and the reason I found the strategy so incredibly worthwhile: if the bust scenario played out, I would likely make profits in the range of 300% – 2000% on those put options. In a sense, I was making a “Black Swan” play. I had studied market history extensively. Historically, boom markets developed gradually, while busts played out rapidly. This is why my strategy was viable; rapid busts made buying out of the money put options extraordinarily profitable if there were a crash.
Of course, since this would only be a 2.0% position in the portfolio, I wouldn’t be achieving 1000% returns on the portfolio. Rather, those positions would give the portfolio perhaps a 1000 – 2000 bps benefit, which of course, is pretty huge for a 2.0% position. I would likely lose a good chunk on the long side, but the put options positions would offset it and potentially allow me to make a profit.
I should note that in addition to the put option strategy, I also held a sizable cash position. I’m still a firm believer that the best way to make money investing is by buying cheap stocks. And ultimately, a good sized cash position can allow you to take advantage of opportunities when they become available. This can help forgive your mistakes elsewhere. I won’t spend too much time expounding on the cash position, because I’ve written about it extensively before, except to say that I tried to stay around 20% – 30% in cash in 2013 and 2014.
I ran a shoestring operation, so I had to test my strategy the old-fashioned way: watching how my portfolio performed in response to certain market movements. In particular, any time there was a down day in 2013 or 2014, I was obsessively watching the portfolio to see how it reacted.
On a big up day where, for example, the market was up 1.5%, I might have been lagging behind at 0.6%. There were a lot of those kinds of days from mid 2013 to mid 2014, unfortunately. On a moderate down day, where the market was down 1.0%, I might only be down 0.2%.
Where it became really interesting was the big down days. There weren’t a large number of big down days in 2013 or 2014, but there were a few times where the market had dipped by more than 2%. On those days, I was almost always up a bit; maybe +0.3% or +0.5%.
While these are not precise estimates and merely a re-telling of things I noticed anecdotally, the bigger point here is that the inherent leverage in the put options was taking over on the big down days and driving massive returns on these small put option positions. The returns were great enough to completely offset losses on the long-side.
Since I never saw a 4% down day, I don’t know how the portfolio would’ve responded for sure, but given what I did know, it’s easy to speculate that I could’ve easily been up +1% to +2% on those types of days. Over the course of a few months of observing how the portfolio reacted to different market movements, I slow recalibrated until I felt like I hit the right balance.
My portfolio results in early to mid 2013 were relatively strong. However, this had little to do with the China put strategy. In fact, the strong returns were driven mostly on the strength of long positions in the homebuilders, as well as my positions in Genworth Financial (GNW), Howard Hughes Company (HHC), and PNC Financial (PNC). I started winding down the homebuilder positions in 2013 and increasingly found it difficult to find great bargains on the long side. As the market continued to move upwards, I grew more concerned about hedging.
From October 2009 through July 2013, I achieved 21.7% annualized return. This was compared to a 12.1% annualized return for the S&P 500 during the same time frame. Even more impressively, from the period running September 2011 to June 2013, I generated a 35.4% annualized return, compared to a 15.5% return for the S&P.
My big period of underperformance began around August 2013. From Aug 2013 through June 2014, when I was dismissed, I generated a +4.0% return versus the S&P 500 return of +16.3%. It was my worst period of underperformance since the 12 month period running from May 2010 – April 2011. Without the put option strategies and short positions, it’s likely that my returns would have improved somewhat; but it’s still doubtful that I would’ve matched the S&P’s impressive performance without taking what I viewed as “bad risks.” Given this, I’m not really sure that I would have been saved merely by avoiding the put option strategy and certainly, my 2015 returns would have been much lower without those strategies.
Interestingly, much of that underperformance was highly concentrated in a few months, particularly August 2013 thru December 2013, as well as Feb 14 and May 14. During the down market months, I outperformed significantly. In Jan 2014, the S&P fell -3.56%, while the portfolio I managed was up +1.01%. Based on this strong month, I was actually even more convinced that my strategy was the correct one.
Unfortunately, my client dismissed me at the end of June 2014. He never gave explicit reasons, but I assumed it was a combination of factors. We had more disagreements in our last few years and that was likely part of it. He was also more involved with angel investing and wanted to focus on those sorts of investments.
I do suspect, however, that the 10-month period of underperformance played a significant role. My client was a very smart entrepreneur who had major success in the past, but patience was probably not his strongest suit. I always felt he was on the verge of dismissing me in mid 2011 after I had a run of underperformance, as well. Having a 2-year run where I generated some of the best risk-adjusted returns in the world not long afterwards might have saved me that time.
Investing is truly a long-term pursuit and one that requires significant patience.
Results of the China Put Strategy
Given my dismissal, it’s more difficult to accurately determine the exact performance of the China put strategy. I do not trade options in my personal portfolio and have needed liquidity the past 12 months; something that the option strategy was not ideal for. For this reason, I merely have to speculate based on the price charts for 2016 put options on FXI.
Based on what I’ve looked at, it would appear that my positions would’ve been up about 500% – 800% since early April, when I almost certainly would’ve increased them. This would’ve added somewhere from 1000 bps – 1600 bps in performance to the portfolio. We’ll average it out and guess 1300 bps.
The profits on the put option strategy are offset in some part by my long positions. My long positions would’ve accounted for about 65% – 70% of the portfolio. In 2015, I have increasingly moved into the energy sector with a focus on low-cost natural gas E&Ps. These positions, like the homebuilding stocks in mid 2011, have been hit hard. For instance my position in Ultra Petroleum (UPL) was initiated around $12. It briefly rose to $18 before plunging down to $6.50. That would be my worst performing position, alongside a few other natural gas E&Ps that were hit for 20% – 30% drops.
My financial stocks such as Banco Santander (SAN) and Citi (C) are a mixed bag; SAN is down about 10% and C is flat from where I bought in. Most of my other large positions are in safer dividend-producing stocks such as Southern Company (SO), which have also taken smaller hits in the 10% – 15% range.
Meanwhile, I have a few stocks that have held up remarkably well. Compass Diversified (CODI), a position I wrote about here at Seeking Alpha, is only down about 5% on the year and pays out an 8.8% annual dividend, so in reality, it’s only down about 1%. My AGCO (AGCO) long position is up about 10% on the year and I actually started trimming the position greatly over $55 meaning I locked in good-sized gains of about 20% – 25% on it. Moreover, in Jan 2015, it was my largest position.
Overall, I’d estimate that the long portion of the portfolio would probably be down about 15% overall as of August 24th. That means it would probably account for about 1000 bps drag on the portfolio.
Aside from that, most of the other positions were short and probably accounted for about 5% – 10% of the portfolio. Those positions would be up right now and might have added another 200 bps of performance.
As of the evening of August 24th, 2015 (the day of the most recent “bottom”), the net result would likely have been a gain of about 2% – 5% on the portfolio for the year after. The S&P 500 index was down about 8% at the time, so that would be a pretty great outperformance.
Purchasing Power is Vital
That brings me to one of the most underestimated aspects of investment: purchasing power. I rarely analyze my investment performance based on returns alone. Rather I look more at what I call “purchasing power.”
What I mean by this is that cash is more valuable in a down market than an up market. In an up market, stocks are becoming more expensive, so every $1 buys less than it did before. In a down market, it’s the reverse; stocks are becoming cheaper and every $1 buys more than it did before. In other words, your cash gains more purchasing power when the market is going down and loses it when the market is going up.
This is an important insight. This is why a well-designed long / short portfolio model is the best in order to generate superior long-term returns. Making +5% in a market that is down -10% is better than making +20% in a market that is +14% in most cases. Even a -5% or -10% return in a -30% market is very good, because while you are technically losing money, your purchasing power is greatly increasing. Indeed, I’d rather have a -5% return in a -30% market than a +20% return in a +14% market, because I know in the former situation, I’ll have the resources to continue buying depressed stocks and generate superior returns in the future.
This is why put option strategies can be so useful. The profits from my 2011 commodity producer put options positions allowed to buy into depressed homebuilder stocks. This supercharged my returns over the next 18+ months. The profits on the put options were “valuable” precisely because they provided me with more cash to buy into securities that would generate extraordinarily high IRRs.
Similarly, the biggest benefit of this put option strategy isn’t making a +2% or +4% return today, but rather, using that increased purchasing power to increase my stake in more depressed stocks. Right now, the area that most attracts my attention is natural gas E&Ps, which I significantly upped my stake in on Monday, August 24th. I hope to write more about the natural gas E&Ps in the upcoming weeks. I see many of the low-cost producers in this sector as being extremely beaten down.
Option Strategies and Hedging
I’ve been an open book about a lot of my investment strategies. Over the years, I’ve authored several articles on large cap, midcap, and even small cap stocks I’ve been buying. I’ve written about several of my major theses, too. Yet, I never wrote much about my put option strategies until now.
There was a good reason for this. While some of the put options strategies were among my most interesting ones, there is much less liquidity in the options market than in the US stock markets. I could write several articles about a midcap stock and have little influence over the stock price. If I wrote directly about my option strategies, if even 2-3 people were convinced to follow my lead, it could’ve hindered my ability to get the most attractive prices. Therefore, I was much more secretive about these strategies, in spite of being tempted to write about them before.
Yet, in my near 5 years as a Portfolio Manager, I found that option strategies provided significant benefits. For deeply depressed stocks, long-dated call options could help supercharge returns with limited risk. Put option strategies were often better at helping limit downside risk than directly shorting stocks, as well.
Option strategies require a lot more expertise and skill than directly buying into stocks, but can be quite valuable to the skilled investor.
As For Me
After my stint as a Portfolio Manager, I tried out being a Newsletter Author for the past eight months. I created the Contrarian Value Newsletter, which in hindsight, seemed to be pretty spot-on about the 2015 market. Nevertheless, I struggled to make the business model work and found that I simply did not enjoy the process.
Now, I’m looking for my next challenge in the investment management sphere. If you happen to be in the market for a very intellectually curious, contrarian value oriented L/S Portfolio Manager or Strategist who developed a spectacular record of risk-adjusted returns from 2009 – 2014, you could say I’m available.
In the meantime, I’m probably going to focus on producing more content for my side project, Huneycutt Investment TV in the upcoming months.