Hedging Hope

Those that regularly follow my articles and forecasts can easily ascertain that I am a worry wart. Fortunately, or unfortunately I am always skeptical on overly optimistic views on stocks and the economy.

So what am I skeptical on now?

I am skeptical on the supposed turn around in the Canadian economy. Yes, things have improved over the last quarter, but I simply do not think that the fuel for this turnaround is sustainable. The global economy has extraordinary challenges ahead of it, which is likely to act like a cold wet blanket on the recent hot commodity market. Yet, traders and investors are looking at the January lows as the end of the commodity bear market and have been buying in sheer madness, driven by the fear of missing a perceived bottom.

This entire cycle is predicated on HOPE.

Hope that the worst is over in China, hope that Europe remains stable, hope that the U.S. does not fall into a recession, hope that global demand for commodities begins to manifest itself.

I ask- what if this “HOPE” is just wishful thinking?

Personally, I want to hedge that hope. It is not about panicking or shorting the markets, it is more about recognizing that this rally may not have the underlying fundamentals to support a sustainable expansion.

So what can we do? Protect oneself.

Let’s look at an example. I want to focus on Canadian banks with an example using Royal Bank. The Canadian banks have had a great start to the year. Royal Bank has traded as low as $64.00 in January and has now recovered $14.00 from its lowest levels and is now pushing new 52 week highs at $78.00 a share. This financial recovery has occurred at the same time as many European, Chinese and Japanese banks face extraordinary headwinds and many U.S. financials that still remain well off their previous highs. These Canadian banks are somehow trading like we are in the midst of a new commodity bull market and that all of the risks from energy company loan defaults have somehow been averted.

In this example, we have an investor that owns 1,000 shares of Royal Bank and is focused on dividends and longer term appreciation. After having experienced the $14.00 rise in share value over the last 3 months, this investor is looking to hedge the downside risk and lock in recent gains. So what can our investor do?

• Investor owns 1,000 shares of Royal Bank valued at $78,000.00
• Investor buys 10 June 17^th $76.00 put options
• The options are asking $1.10 (April 29^th 2016)
• The investor pays $1,100.00 for the puts ($1.10 x1000)

What has the investor accomplished?

By having spent some of their profits on buying the puts, they have secured a guaranteed sale price of $76.00 per share over the next 6 weeks. If the investors’ concerns of a drop are unfounded and Royal Bank shares continue to rise, the investor still owns the shares and has 100% of the upside. Alternatively, if the market reverses and heads lower, the investor has a protective put that removes all downside risk below $76.00 between now and June 17^th.

Some buy and hold investors are willing to expose themselves to unconstrained downside risk, but personally I always feel most comfortable being invested knowing that the risk is managed and the worst case scenario has been hedged.