You've been spooked by the stock market's hair-raising volatility, but you don't want to bail out of equities. What can you do? Depending on the size of your paper profits, your outlook for the market, and your risk tolerance, you can use hedging strategies as complex as options or as basic as zero-coupon bonds. Done the right way, they can help protect you against a market swoon while still letting you earn capital gains if stocks climb higher.
Historical performance data suggest there's good reason to remain exposed to equities, especially if you're investing for the long haul. Since 1925, estimates Ibbotson Associates, small-company stocks have earned an average of 12.6% a year, while large-company stocks have returned 10.7%. Long-term U.S. government bonds, by contrast, have earned 5.1%, and Treasury bills a mere 3.7%. Hedging costs will eat up some of those excess returns, of course. But you do have history on your side.
CLASSIC. One kind of shield is to buy convertible bonds. But the classic instrument to use when you want to protect your position in a stock with a big gain is a put option. A put gives you the right to sell 100 shares of a stock in the future at a "strike" price specified today. Regardless of how far the stock drops, the put guarantees you a minimum selling price--and thus, a profit--until it expires. If the stock falls to, say, $5 below the strike price, your put is "in the money" and worth at least $500, depending on how much time remains on your option contract. You don't have to sell your stock; as the price falls, the value of the put rises and offsets losses on your stock. "Puts are really just financial insurance," says John Markese, president of the National Assn. of Individual Investors.
You pay a premium for that insurance: the cost of the put, plus commissions, ranging from $20 to $60. Take Motorola, whose stock was trading recently at 64 1/2. A Motorola put with a strike price of 60, expiring in April, 1998, will cost you $450, plus commissions. Contracts usually run up to eight months, but can stretch as far as three years. Long-range puts are called LEAPS, for long-term equity anticipation securities, and are available on indexes as well as individual stocks. "Everyone who uses options should have an opinion on a stock's price--how far it will move, and in what time horizon," says Terry Haggerty, a senior staff instructor with the Chicago Board Options Exchange's education department. Options are traded on the CBOE and the American, Philadelphia, and Pacific Coast exchanges.
A way to offset the cost of a put is to sell a call option against your stock at the same time. A call gives a buyer the right to purchase your stock in the future at a fixed strike price. Combine it with a put and you have created a "collar" (table). You'd employ a collar if you still think there may be modest potential for a stock to gain. But you'll give up any big profits if the stock explodes.
You may want to use a collar if you have a significant percentage of your assets tied up in one stock. You can also buy puts and calls on 60 stock indexes. They work the same way as they do on stocks. Whether you want to hedge indexes or individual stocks, a collar's cost is the difference between what you get for selling the call and buying the put. But you should use this strategy with care. Rolling over puts and calls after they expire can get expensive. That's why Haggerty suggests limiting their use to periods when specific events might drive the market down.
If you're especially bearish but would rather not delve into options, you might want to shift some of your portfolio into a contrarian mutual fund (BW--Mar. 17). Through the use of short selling and puts, bear funds try to hedge against a major market crash, or even profit from one. Most bear funds have turned in terrible returns in recent years as managers found themselves fighting a seemingly indomitable bull market. But October's upset gave a few of these funds an opportunity to shine.
Take Prudent Bear, a 1-year-old fund with $55 million in assets run by independent money manager David Tice. For the year ended Oct. 31, it lost 10.92%, vs. a 32.1% gain for the Standard & Poor's 500-stock index. But in October, it became the nation's top-performing mutual fund, according to Morningstar, returning 9.6% while the S&P fell 3.34%. Tice now expects a 45% market decline within the next 18 months. He has sold short 70% of his portfolio's assets, of which half are in technology stocks such as Micron Technology and 3Com. Tice also owns puts on America Online, Dell Computer, the S&P 500, S&P 400 Midcap, and the Morgan Stanley High-Tech indexes.
TOO EXTREME? Another bear fund, Rydex Ursa, gained 2.28% in October, which also made it one of the top performers. But it still is off 20.38% for the year. Mathers Fund, Comstock Partners Capital Value A, and Comstock Partners Strategy A also did slightly better than the market in October. Two other bear funds are Linder Bulwark and Robertson Stephens Contrarian A.
If bear funds are too extreme for your tastes, you might think of amassing a portfolio of defensive stocks that have little correlation to the movements of the overall market. An easy and cheap way to sift through the thousands of stocks available is to plug into one of the stock-screening sites available on the Web (BW--Sept. 22). Telescan's Wall Street City (www.wallstreetcity.com) is one such spot. We recently asked it to search for stocks with common defensive characteristics: low volatility over the past month, trading volumes of at least 100,000 shares a day, low price-earnings ratios, strong balance sheets, and market capitalizations of more than $1 billion. It came up with 10 that weathered this year's three market downturns better than the S&P 500.
Telescan's lineup: Raychem, Tektronix, Alcan Aluminum, Echlin, Lyondell Petrochemical, Hanson, Armstrong World Industries, Avnet, Snap-On, and Aluminum Co. of America. Except for Alcan, these companies all recently traded in the upper half of their range. The average p-e of 17 for the group, well below the 23 for the S&P 500, makes these stocks value plays. Of course, this list is just a jumping-off point for additional research.
What if you're ultracautious? In that case, consider buying zero-coupon bonds in combination with stocks. That way, you ensure you can't lose your original investment. Zeros guarantee a rate of return on your principal. They are sold at a deep discount to their face value, similar to U.S. savings bonds. Say you have $15,000 to invest. Take $8,200 and buy a $15,000 U.S. Treasury zero yielding 6.12% and maturing in 2007. Then take the remaining $6,800 and put it in equities. Assuming a conservative 8% annual return in stocks over the next 10 years, you will earn $14,680 by the time the bond matures. Even if the value of your stocks were to fall to zero by 2007, a highly unlikely prospect, you'd still get $15,000 back by cashing in the bond. "With zeros you know exactly how much you'll get on a particular day," says Gary Schatsky, a New York-based financial adviser and attorney. But to make this strategy work, you may have to hold the bond to maturity. Schatsky points out that the value of a zero can gyrate more wildly than that of a conventional bond. "They are the most interest-rate sensitive, and thus volatile, of all bonds." You also have to pay current taxes on interest accrued on zeros even though you don't get the cash from the bond until it matures.
Indeed, all of these strategies have some risks attached. But if you believe in the value of owning equities, they may help you keep the stress level down while waiting until the market's jitters subside.