Investing and Egypt

So the people (or at least some of the people) of Egypt are in the streets protesting/rioting against the rule of Hosni Mubarak. The government of Tunisia was just overthrown in the same manner. There is rioting in Yemen. Maybe the Saudi royal family will be next. In short, there is an extreme amount of uncertainty being injected in the world economy. Tunisia and Yemen we can deal with, but Egypt (and Saudi Arabia) are key parts of the economic and political order of the Middle East. No one knows what Monday will bring. Maybe Mubarak will have managed to bring down the anger level so that he will survive. Maybe there will be a new democratic government headed by Mohammed El Baradei, of atomic bomb control fame. Maybe (God forbid!) the Moslem Brotherhood will be in charge in Cairo. That's the point; no one knows.

All of this has a bad effect on the world's stock markets. Investors hate uncertainty and they flee from it towards safety when it rears its ugly head. Just imagine! What if the Suez Canal gets closed and world oil prices spike by 50%? What if the radicals take over in Egypt giving the terrorists a truly major country to help them? What if Saudi Arabia with all of its oil is threatened?

Anyone who invests in the stock market needs a strategy as to how to deal with this eventuality. So what should the strategy be? In my view, it is a two part one.

First, one needs to decide how severe the threat to the economy truly is. Obviously, if one expects a total disaster, one needs to get out of investments that will tank in that event. Right now, however, it is premature to assume the worst, in my opinion. So that takes us to the second point.

Second, one can put money into highly leveraged hedges that will protet portions of ones portfolio in the event of a decline. There are four basic types of hedges that I would suggest. The first is buying something that will go up as the stock market index goes down. My favorite investment here is options on SDS, Proshares Ultrashort S&P 500. SDS goes up by twice the amount that the S&P 500 goes down. For example, if the S&P declines by 3%, SDS should go up by 6%. In order to leverage this position further, one can buy calls on SDS. This makes the return on investment much greater. For example, at the close on Friday, SDS was selling for $23.01. If there is the same 3% drop in the S&P, SDS will go up 6% to $24.40; at the same time, however, the February 23 calls would rise from about 78 cents to something like $1.55 -$1.60. In other words, an investment in SDS calls would double on a 3% drop in the S&P. What this means is that a small investment in SDS calls can offset a widespread drop in your other holdings.

A second protective investment is to buy options on treasury interest rates. Frequently, when there is trouble around the world, investors flee to the safety of US treasuries and drive the interest rates down. My favorite investment here are puts on TBT, Proshares Ultrashort 20+ year treasuries. TBT is a fund that rises twice as fast when interest rates on long term treasuries rise. That means that it would decline were there to be a rush to the safety of treasuries. Accordingly short term puts on this stock would rise very quickly in that event. Obviously, given the state of world markets, US Treasuries are no longer the haven that they used to be, but they still remain the most likely place for investors to park their funds for safety, so the TBT puts seem like a good hedge right now.

A third protection is gold. There are many reasons people buy gold. One of the oldest is that it is a store of value in times of economic upset. This was apparent Friday as gold went up nicely after a long period of decline even as the rest of the markets were falling. Here too, I think that options on the gold exchange traded fund GLD is the way to go. GLD closed Friday at $130.28, up a little over $2 for the day. with this small percentage movement, however, one can still obtain big protection through the use of options. The February 19 calls with a 130 strike price closed at $2.27. The prices indicate, however, that a $2 rise in GLD would lead to a 50% rise in these options. So, here too, a small investment can be used to offset possible losses on the rest of ones portfolio.

The fourth protective investment is a much more general one: writing covered calls on one's holdings. For example, say that you own stock in Corning which closed at $21.80. If you bought it at $19.32 when I recommended it a month ago, you have a profit of $2.48. If you write the March 22 calls, you could take out 76 cents, or about a third of that profit. If the market declines, you get to keep that 76 cents. On the other hand, if the market rises, you have agreed to sell the stock on March expiration for $22 plus the 76 cents. that means that you have capped your gain at $3.44 for the investment. Given the protection that you gained, this seems like a good deal to me.

You can use one or all of these methods to protect your portfolio. To be sure, none of them will be adequate to protect you if there is a disaster like there was in 2008. For smaller gyrations, however, these methods can certainly smoothe out the bumps.

For the first three methods, there is a clear up-front cost. I view that cost as if I were paying an insurance premium. I would rather not recover on the policy even though I am glad I have the protection.

WARNING: Most of these strategies are highly leveraged and need constant supervision. You have to decide for each when it is time to cash in or to close out the protection. They are not fool proof methods, either, since the market frequently has a mind of its own. They are methods, however, that a skilled trader can use to great advantage. If you are initerested in any of them, please do your own due dilligence to determine if they are right for you.

Disclosure: I have and am currently using each of these methods.