Notes from an Investor Who Avoided Large Losses This Year, Part II

Below is the continuation of Buffetteer17's notes on his hedging strategy (click here for Part I):

A few words about those S&P 500 index put options. I bought them at market highs last year. I was concerned that The Portfolio was doing too well. In Oct. 2007, it was yielding a CAGR of 39%. And that was return on assets. The return on equity was higher, about 50%, since I was about 20% on margin. While I might dream that I was the second coming of young Warren Buffett, when I woke up, I knew it wasn't so. It was largely luck, leverage, and a 3 year bull market, and---perhaps---a little bit of skill. I did not predict the bottom would fall out of the market, but I did consider what would happen to a leveraged portfolio if it did. So I decided to sacrifice a few percentage points of returns in exchange for market crash insurance. I bought S&P 500 index puts with a face value (sum of strike prices) of about 2x the size of The Portfolio. Average strike price was around 1250 and average time to expiration around 18 months. The two key objectives were to put in a floor below which The Portfolio is very unlikely to fall, and to provide funds to meet margin calls if they come. Most of my put buying was around S&P 500 level of 1500-1550, so the options would not protect much against moderate drops, say 20%. But they would become extremely valuable on a drop of 40-50%. The cost of the puts was about 6% of The Portfolio. Given that the lifetime of the options is about 18 months, and that the cost is deductable (assuming they expire worthless), this would hurt my total return by about 3%/year. As it happened, the damage is already reduced to about 1%/year, since I sold a few the puts on 1/22/08 and 3/7/08 for incredible percentage gains. Without the puts, my loss this quarter would have been 22% instead of 16%. The puts don't really fully kick in until S&P 500 level of about 1250.

Q2-08 (hedge 13.2%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 2x the stock portfolio, with strike prices varying from 1350 to 800, and expirations of 12-18 months. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. During the market dip in late June, I sold down a little. This reduced my basis cost for the options to 2.5% of my portfolio and the remaining options are up 186%. I'm in no danger of being forced to sell undervalued stocks due to a margin call. If the S&P 500 drops further and my stocks drop proportionally, I'll actually gain quite a bit, since the options are now sufficiently close to the strike prices that they have quite high deltas. I estimate that the existence of the hedge has added 3.7% to my returns since inception.

Q3-08 (hedge 10.8%) The hedge comprises a number of S&P 500 index put options, with a face value (sum of strike prices) of about 1.5x the stock portfolio, with strike prices varying from 1250 to 800, and expirations of 12-18 months. I bought the hedge a little over a year ago, at a cost of about 4% of the portfolio value. I had no idea that the stock market would crash and the economy would enter recession. But I was concerned about the collapsing housing market and early hints of a credit freeze. I figured I would take out some cheap insurance, just in case. The hedge is doing its job fairly well. That job is to insure against margin calls and put a floor under my net worth. The floor turned out to be a little lower than I planned, because my stock portfolio declined faster than the S&P 500 index. This quarter I sold about 1/4 of the options. By now, the profit from the hedge is so much that even if the remaining options expire out of the money, the hedge has more than paid for itself. This has been by far my best investment of the year, with returns north of 300%/year. Too bad I didn't put more money into it.