How to use a volatility Call Spread as a Downside Hedge?

on Mar 22, 2015 in Derivative, Equity, Home | 2,098 comments

One way to hedge the downside risk in your portfolio over the following three months is to purchase some put options. The exchange-traded fund SPY tracks the S&P 500 index, is highly liquid and makes a nice proxy for your US equity holdings. If you purchase the adequate out-of-the-money puts on SPY to hedge against a 10% market decline for your entire portfolio, you’ll pay about 3% of portfolio value. It is only under the condition that the market slumps more than 13% (10% decline plus 3% cost for the put premiums), that you have put a floor under which the portfolio is covered. Is that actually the best strategy to play? The call spread option trading strategy on the CBOE Options Volatility Index (VIX) might be the solution. In my view, this could be an interesting indirect theme to play. Remember, if the market goes down the VIX will go up. And if the market really pukes, the VIX will roar higher. Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying and the same expiration month. By shorting the out-of-the-money call, you reduce the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the volatility skyrockets. As the market continues to shoot to all-time highs, this strategy would act as a complementary trade to your portfolio since volatility typically expands when the market sells off. Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement which is why I often think of the VIX as an indicator of relative market stress. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets. Currently the VIX is trading at 14.07. Its 52 week range is 10.28 – 31.06 and this indicates to me that there is still a relatively high level of complacency in the market despite the global economic uncertainty and equity markets shooting to all times highs. Keep in mind that at the height of the financial panic in 2009 it touched 80. Let’s look at the VIX April contract 16-20 call spread. This spread is trading at 0.85, which seems cheap to me. A VIX at 20 or higher will more than triple your investment. That means that if the VIX is over 20 in the following month (not at all unlikely, and under the 52-week high) the spread will expire at four. So, you are risking less than one to make more than three, I consider it to be a highly favorable risk/reward ratio in this market environment. This strategy could be a way to hedge your equity portfolio against a major move lower, albeit perhaps...

Is it overvalued? Look at the PEG Ratio

on Nov 25, 2014 in Equity, Home, Portfolio ad hoc | 1,820 comments

Many investors rely on popular measures, such as price-to-book value and price-to-earnings ratios. One measure investors like to look at, especially during times of rising stock prices is the price-to-earnings to earnings-growth (PEG) ratio. The price-to-earnings (PE) ratio divides a company’s share price by its earnings per share to give a rough indication of relative value. A relatively low PE doesn’t necessarily translate to an attractive investment opportunity. For this reason, some analysts prefer the price-to-earnings to earnings-growth (PEG) ratio. Believers in the PEG ratio think that the PE by itself is of limited value. Some companies are more expensive, or have higher valuations, than others. But that higher price tag may be worthwhile if the company is growing more rapidly. The PEG ratio is a way to quantify this mindset. The PEG ratio takes a company’s PE ratio and divides it by earnings per share growth. For example, company XYZ has a share price of CHF 40 and earnings per share of CHF 4. This gives the company a PE ratio of 10. If the company’s earnings per share growth is 10%, the PEG would be 1. It’s assumed that a fairly valued company has a PEG of 1. Suppose now that the company’s earnings per share tumbles to CHF 2 and the stock price remains CHF 40. Now, the company’s PEG is 2 assuming earnings growth remains constant at 10%. This implies that the company is overvalued. In other words, investors are paying an unjustified premium given the current growth rate. There are some drawbacks to using the PEG ratio. First of all, XYZ is not going to grow at a 10% growth rate forever. The PEG ratio doesn’t suggest how long the 10% growth rate will persist or what the growth rate is likely to be 5 or 10 years from now. Also, when compared with more detailed discounted cash flow analyses, the PEG ratio tends to undervalue companies with extremely high, almost exponential growth rates. While far from perfect, the PEG ratio still helps gauging relative value. Use it...

High dividend strategy

on Mar 10, 2013 in Equity, Home | 2,143 comments

A High Dividend Strategy is structured to provide for the higher cash flow needs of the income oriented investor. The strategy seeks to provide both a stable and growing income stream while also giving clients less volatile participation in market movements, while providing principal protection during periods of rising interest rates. However, with all investment stories, there are caveats and these are the most significant ones for High Dividend Strategies: Dividends are not legally binding: Unlike coupons on bonds, where failure to pay leads to default, companies can cut dividends without legal consequence. Liquidating dividends: When companies are in decline, they may pay large liquidating dividends, where assets are sold to fund the dividends. Dividend yield for a share shoots up mainly due to price drops, not because the dividend is increased. Sometimes price drops occur because there is trouble looming on the horizon. Higher tax liability: At least in Switzerland, dividends have been taxed at a higher tax rate than capital gains. Sector concentration: If you pick the highest dividend yield shares, you may find yourself holding shares in one or two sectors. In early 2008, for instance, you may have ended up with five banks in your portfolio. Considering the shock to that sector end 2008, your portfolio literally collapsed! By screening  tax-advantaged, dividend paying shares, for suitable candidates with a market-cap greater than CHF 5 billion, above average dividend growth, investment grade debt rating, and candidates that have not have been forced to cut their dividend over the past 5 years, should provide confidence that the dividend payout is sustainable. Once a candidate has been identified, a thorough fundamental analysis of the company focusing on valuation and key balance sheet and income statement information should be conducted. With such an approach, you can construct a reasonably diversified portfolio by owning 30-40 securities spread across sectors, although higher dividend sectors such as for instance utilities will have larger...

Closing the gap between gold price and gold mining companies prices

on Oct 25, 2012 in Equity, Home, Precious metals | 1,778 comments

In an environment of ballooning sovereign debts and major central banks expanding their balance sheets aggressively, real assets, such as gold, should increase in value. Over the last few years, the physical price of gold has risen steadily, outperforming the S&P Metals & Mining Select Industry Index which tracks the world’s leading gold companies. The divergence of gold price and gold mining share prices is an example of a market dislocation. Historically, the two move tightly together. The logic is simple: When gold price rises, the mining companies sell their gold for higher prices, and increase therefore there bottom line. The two main reasons for this performance bridge are the following: Through the invention of Exchange Traded Funds, investments have been drawing away from gold equities. These funds, allow investors to own gold without having to worry about storage, insurance, transportation, purity, reselling…Gold ETF’s have grown significantly in size and are now a big player in commodity investing. The mining shares have additional risks related to production costs, geopolitical risks, fraud and corruption, resource nationalism, infrastructure access…A decade ago the average cost of extracting an ounce of gold from the ground stood at USD 200. Nowadays replacing depleted reserves is becoming harder. For instance, Barrick Gold’s extraction cost went up from USD 440/oz to 505 USD/oz in 2011 and this trend is likely to continue. However, as more investors move towards gold as an investment, people will look for new ways to be long gold without actually holding gold bullion or buying an ETF like SPDR Gold Shares. One way to bridge this performance gap is throughout dividends. Due to higher cash flows that these miners are generating, they have greatly increased their dividend payouts. Some miners have become even more creative and linked their dividends to the gold price itself, and I believe that these attractive dividend schemes could help persuade some investors into the miners instead of into gold. Such changes to dividend policy could mark a paradigm shift in the industry! To conclude, mining companies have had to be more creative to differentiate themselves from other investment vehicles. But would that be...

Key ratios for value investors

on Oct 18, 2012 in Equity, Home | 632 comments

Value investing implies chasing shares worth less than they should be and therefore considered undervalued. Because a share’s price is a combination of investor estimates for growth, revenue and dividends, it is also a matter of opinion as to whether that share is undervalued. The most common way to apply a value measure to a share is Price/Earnings ratio. Dividing a share’s price by its earnings per share is a standard way to grab a snapshot of a share’s value. A very high P/E implies that the share is considered overvalued, however lower P/E doesn’t always account for growth potential. By combining the P/E ratio with a share’s expected 12 month growth rate you derive the PEG ratio. It is one of the best ways to screen shares because it summarizes information about a company’s financial performance in an understandable way. The PEG ratio can offer a suggestion of whether a company’s high P/E ratio reflects an excessively high share price or is a reflection of promising growth prospects for the company. PEG ratio = (Price/Earnings ratio) / annual EPS growth PEG is a widely used indicator of a share’s potential value. It is favoured by many over the Price/Earnings ratio because it also accounts for growth potential. Similar to the P/E ratio, a lower PEG means that the share price is undervalued. An investor would probably be wise to check out the future growth rate by determining how much the most recent quarter’s earnings have grown, as a percentage, over the same quarter one year ago. Dividing this number into the future P/E ratio can provide a more realistic PEG ratio. Occasionally share price reflects more investors’ sentiment rather than a company’s long term profitability. Over time, inefficiencies are corrected and prices realign with intrinsic values. Value investors seek to buy companies whose shares appear underpriced relative to the underlying...

Should you invest in the pharmaceutical sector?

on Aug 30, 2012 in Equity, Home |

The pharmaceutical sector can be a good place to invest. Pharmaceutical firms can enjoy hefty profit margins and have a clearer and longer flow of earnings, especially if they develop the next blockbuster drug or lifesaving treatment, despite the potentially high-risk nature of a business heavily dependent on research and development of new products, and patent protection. At the same time, the developed world is trying to rein in the cost of government-subsidized healthcare. Many investors have abandoned the pharmaceutical industry lately due to the lack of drug pipelines, blockbuster patent expirations, a more stringent FDA, generic competition, research failures, and drug safety concerns. Big pharmaceutical companies have realized the evolving market place and many are undergoing heavy transformations to change the way they do business. For example, many of them are now focused on cutting out the “fat” that they’ve accumulated over the years. Companies are also developing new systems, technologies and sales tools to combat the increasingly hostile environment. Instead of focusing on developing blockbuster drugs, companies are spreading their resources into more focused indications on smaller patient populations. They’re entering newer markets, particularly in Asia where significant growth opportunities exist. They’re also participating in more joint ventures, and acquisitions to prop up their pipelines. Finally, companies are outsourcing many activities like R&D, clinical research and sales to third-parties. The pharmaceutical industry is not only attractive for its high-paying dividend yields. In addition, many companies are currently trading at low multiples to earnings and to sales. Instead of looking for the next blockbuster, the prudent investor will look for where true value exists. There are still great benefits to be reaped! In the end, how can you beat a business that makes a pill for a few cents and sells for a few Swiss...