Shift In Strategy: How I’m Preparing For a Market Crash

by FI Fighter on May 12, 2015

in Real Estate Thoughts, Stock Investing Thoughts, Thoughts

Reaching-your-goals-1

They say that when you’re investing for the long haul, you simply need to stay in the game for long enough and the results will speak for themselves in the end. Markets go up and down all the time; it’s simply the cost of doing business in the investing game! So, as investors, we just need to carry on and block out all the noise…

I wish it were all that simple… But as always, each individual’s strategy becomes unique because each person has their own specific combination of: timeframe, goals (objective), risk tolerance, etc.

For myself, I completely subscribed to the strategy or rapidly accumulating assets during the last market downturn. 4 years later, I couldn’t be any more happy and grateful for all the progress that I’ve made because I elected to invest in a time of fear.

But after 6 years, it’s very obvious to most everyone that this latest bull run has now become overstretched. The market hasn’t had a pullback in quite sometime, and everywhere I look, I’m finding overly exuberant investors who are trying to pile on in this game because “making money is so easy now”…

I live in the Bay Area, and bidding wars are as intense (if not more so) than ever before. Homes are routinely listed on the MLS overpriced, and buyers are yet somehow willing to overpay by another $50,000 or $100,000 above listing. No sweat. Money grows on trees, apparently…

Well, as I’ve alluded to in many of my previous posts, I simply want no more part in this game anymore… Not at this stage when greed is running rampant again.

Cash Out Refis

Earlier this year, I elected to refinance two of my rental properties so that I could pull out much of the equity build up that I’ve experienced these last few years. I pulled out ~$200,000 and at present moment I have about $130,000 in liquid funds.

Almost immediately after completing the second refi, I put my capital back to work and attempted to replenish my individual stock portfolio. Yes, I realize that investing in an index fund will most likely yield higher returns in the long run, but I wanted to handcraft my own personal portfolio to fit my own specific needs — I wanted to roll the dice on some growth stocks, try and identify some future Dividend Aristocrats, and park a great chunk of funds into low beta, reliable large caps.

At present day, here’s what my individual stock portfolio looks like:

Screen Shot 2015-05-12 at 8.12.54 AM

As of 5/12/15

Just like before, when I first started the path to early financial independence in 2012, I was doing what I knew best — building wealth one brick at a time…

Changing Gears

At first glance, I could try and argue that I’ve put together a solid list of holdings that ought to do well over the long haul, once you filter out all the short-term market noise…

And I very well could elect to keep sticking to the gameplan, injecting fresh capital like clockwork as I look to build up the portfolio further…

But lately, I’ve had a change of heart… Although I still don’t regret reconstructing my individual stock portfolio, after recently clearing the $100,000 marker, I think that I will give myself a break and focus my attention back on defense again.

What does it mean to play more defense? My own approach will be to focus on stashing cash and if I do invest fresh capital, I’m going to stick to investing in index funds.

Yup, I’m going back to the tried and true approach; the one I first started utilizing way back in college.

How’s that for unexciting?

Market Crashes Scare Me

Further, as it pertains back to my individual stock portfolio, I’m going to deviate from the typical Buy and Hold approach that many investors like to employ.

Rather, I’ve decided that I’m OK with exiting out of positions, and will gladly take profits off the table right now. Keep in mind, my situation might be atypical to that of many other dividend growth investors out there — I have an ownership stake in 8 properties and over $1MM in debt that I am responsible for. In the event of a disastrous market collapse, I will be encumbered by a massive amount of debt that I will somehow have to figure out a way to manage as the world seeming falls apart. Unlike dividend growth investors who hold no debt, I won’t be able to simply keep on investing, regardless of rain or shine. Rather, my primary objective at that point will be to protect my real estate investments at all costs! The majority of my net worth and passive income are held in real estate, so there’s no way I’m going to let that go without a fight!

In a market crash, you could get hit with more than a few series of whammies. Equity build up gets wiped out. Properties go underwater. Stock portfolios are bleeding red. Tenants can lose their jobs. I could lose my job. Rents could get slashed.

That’s a very scary place to be.

Even though I didn’t experience such devastation during the last down-cycle first hand, I would be a fool if I didn’t plan for the worst!

Market crashes can go on for a prolonged period of time. Should that happen, then I will need to have ample cash on hand to weather those storms. So, again, we are back to stashing lots of cash. I’ve got about $41,000 squirreled away for a rainy day, but I don’t think that’s sufficient… I gotta keep working on growing the pile!

But, perhaps there’s more I can do as well…

Additional Income

The primary reason why I’m investing in individual stocks again is to generate additional income (along with some side hustle appreciation plays). With my own individual stock portfolio, this has been accomplished by purchasing quality dividend holdings such as: Johnson and Johnson (JNJ), Coca-Cola (KO), Chevron (CVX), AT&T (T), Toronto-Dominion Bank (TD), and Realty Income (O).

But as we all know, individual holdings will always be more inherently risky than holding an index fund, regardless of how stable a company may have been in the past; the probability that a Dividend Aristocrat or Champion going bust is low, but NOT impossible!

So, in the interest of risk management, I’ve again accepted the fact that I’m OK with selling off branches of my dividend tree from time to time. One way that I’m utilizing the sell angle is that I’ve started selling covered calls on my positions. That way, if the market pushes prices north of what I’m comfortable with, I’ll gladly walk away, content with not only selling at at high price, but also collecting a premium along the way.

Further, upon closing out a position, I will consider selling cash secured puts to acquire shares of any other companies that I feel are being undervalued by the market. This approach will again let me collect additional income in the form of a premium, and I also get to redistribute the freed up funds from any covered call sales. Again, at this point, I don’t plan on injecting any further fresh capital into the individual stock portfolio, so the funds will only be recirculating as positions are bought and sold into.

I should point out that with this reallocation of funds strategy, I will only look to sell and acquire shares of large cap companies that have a reputation and history of paying a growing dividend. I’m not going to be utilizing covered calls and cash secured puts trading speculative growth stocks! Instead, I will only enter and exit out of positions that I would have been comfortable holding for the long haul, anyway…

If the covered calls and cash secured puts expire worthless, that’s just fine by me; I’ll simply collect the dividends per usual along with any premiums. For all intents and purposes, by simply holding, the results would be identical to following a strict Buy and Hold approach… which was my original strategy all along!

At this stage of the game, it seems like a no-brainer for me.

Here are some covered calls that I’ve recently written:

SBUX May 29 2015 51.00 Call $16.34

KO May 29 2015 42.00 Call $17.66

TD Jun 19 2015 47.50 Call $24.34

T May 22 2015 34.00 Call $10.34 

That’s an additional income of $68.68 for doing nothing. I realize that selling positions and cutting dividend branches is never popular, but as I mentioned above, I’m exiting out of the Rapid Asset Accumulation Phase at this juncture of the bull cycle.

As readers know, I always like to keep an open mind and adapt to market environments. In other words, just because I’m electing to focus on the Wealth Preservation Phase at this time, it does not mean that there won’t be another point in the future when I am again gungho about investing and going full assault into buying up assets again.

Markets go through cycles; I’m going to follow their lead.

Summary

The market keeps going up! As such, I’ve decided to shift gears and rethink my investment strategy. Upon clearing the $100,000 marker on my individual stock portfolio, I’ve decided that it is now prudent for me to stop working towards rapidly building up this fund, but instead to focus more on saving cash and purchasing safer index funds with any fresh capital.

Further, in an attempt to play even more defense, I’m going to start utilizing options to write covered calls and cash secured puts to generate additional income on top of the dividend income. Should my positions be called away, I will gladly give them up at a strike price I deem reasonable for selling.

I’m doing my best to not fall in love with any of my investments. I’ve written 4 calls to start, but will probably continue writing a lot more in the coming months.

Yes, Buy and Hold is a wonderful strategy, but at this time, I do not believe it’s necessarily the best one for my particular stock investment portfolio. I will be brutally honest with readers and freely admit that protecting my real estate portfolio is of paramount importance to me at this time.

By selling stock positions prematurely, you could argue that I might miss out on future gains or be unable to get back into a holding at a favorable entry point. That’s all very possible, but a consequence that I’m comfortable with accepting. I’m not at the beginning stages of my investment career and I’ve planted my fair share of financial freedom seeds; I don’t need to play hero ball, and will now be content with just hitting singles, with a few doubles mixed in here and there. As such, if any stock position I hold gets to a point where I feel that it is overvalued, I will sell.

Investing is never without risk, so we cannot underestimate the importance of risk management in our strategy. For instance, in my own situation, if the markets keep going up, I win… even by doing nothing more. That’s because my existing holdings in stocks and real estate will likely keep increasing in value. However, if I keep rolling the dice and the market does decide to crash, I could be left facing some serious pain! But if I’m able to toughen out the next crash by playing strong, intense defense, then I should be able to get past any hurdles unscathed. When the market inevitably rebounds again, I’ll be able to go back into Rapid Asset Accumulation and buy up everything in sight…

No one said investing was easy! Just like life, things don’t always proceed in a straightforward, linear trajectory. I’m deviating a bit from my comfort zone, but hopefully I’m doing the right thing at the right time…

In any event, live and learn! 🙂

 

Fight On!

{ 18 comments… read them below or add one }

1 mark May 13, 2015 at 7:40 am

well i wish you success.

Reply

2 FI Fighter May 13, 2015 at 8:16 pm

Thanks Mark!

Reply

3 Financial Samurai May 13, 2015 at 1:02 pm

You can always short real estate stocks and indexes if you want.

The best recommendation I can have for you to survive a crash is to try and go back to work before the crash. Once the crash happens, it’s going to be that much tougher.

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4 FI Fighter May 13, 2015 at 8:17 pm

Sam,

I can’t say I have the knowledge, skills or experience to try shorting… I think I’m going to stick to hoarding cash for the most part.

Depends on the line of work, I guess… Hopefully I’ll have my realtor’s license before then.

Cheers!

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5 No Nonsense Landlord May 13, 2015 at 3:18 pm

Index ETFs can still go down, but likely not as fast as some of the individual stocks you own.

Selling covered calls is a great way to get some extra income during sloppy times. You can often roll them over to the next period, with additional income, if they get away from you too.

If times get tough, you can always give a property back to the bank. Or fire-sale it if there is any equity. But that is a last resort. I have a lot more capital than $41K, and a lot less mortgages, and I would feel naked with only that much available.

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6 FI Fighter May 13, 2015 at 8:19 pm

Eric,

Yes, at this point I’m thinking the individual portfolio has grown enough where I should focus more on holding cash now.

$41k might be pennies for you, but we aren’t all multimillionaires now, are we? 😉

I’ve been doing my best to build up my real estate while making sure to build up cash reserves as well. I gotta admit, it’s not always that easy to do… But if I can get to $1MM at age 30, I ain’t going to be complaining.

Can’t wait until the day I get to say $41k is chump change…

Cheers!

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7 beth May 14, 2015 at 7:54 am

Do you think there is a chance that interest rates may start to rise? If I thought that I would put more money in to GICs, guaranteed income certificates that are like your American CDs, instead of continuing to put money in to my brokerage account.

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8 FI Fighter May 14, 2015 at 8:06 am

Beth,

Perhaps, but I think it will be very gradual and not an overnight phenomenon. I’m not too concerned with rising rates, overall, but more with how long this bull run has persisted for and how much euphoria is in the air.

I’m not trying to be doom and gloom, perhaps we even still have a few years of running left ahead, but I’m approaching this from a purely risk management point of view — If the market keeps soaring, I come out ahead… If the market tanks, I’m screwed (potentially)!

In regards to the brokerage account, I’ve definitely eased up and am focusing more on cash these days.

Again, perhaps nothing will happen and I’m just being overly paranoid… But if something does happen, it’s usually only most obvious after the fact.

Better to be safe than sorry 🙂

Take care!

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9 Nuno May 14, 2015 at 9:28 am

Just for my understanding:

SBUX May 29 2015 51.00 Call $16.34

means

if “price of SBUX at May 29” > $51.00
then “you sell the shares at $51.00”
else “nothing happens”

Reply

10 FI Fighter May 14, 2015 at 9:35 am

Nuno,

Yes, if the shares are above $51.00 and the option is exercised, then my 100 shares (1 contract) will get sold off.

Regardless if that happens or doesn’t happen, I collected $16.34 for selling that option.

Essentially, I’m making the move to earn extra income, which can be seen as an additional dividend distribution at a sell price that I am comfortable with.

Hope that helps.

Cheers!

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11 Nuno May 14, 2015 at 10:29 am

Thanks, in Portugal we barely have options and covered calls are “science fiction”…
Your explanation really helped.

Are there “covered puts”? And could you do something like this?

SBUX May 29 2015 51.00 Call
SBUX Jun 26 2015 45.00 Put

Just in the case you don’t mind to buy more shares at $45 ?
This kind of strategy can give some extra cash with lot less risk no?
Sorry if this is trivial to you, I was thinking while writing. I’m not familiarized with this kind of options.

Is there a website where to see the covered calls quotes?
Thanks

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12 FI Fighter May 14, 2015 at 11:08 am

Nuno,

Yes, you can buy or sell calls and puts. In the case of puts, if I want to own a stock at a discount I will sell cash secured puts.

For example, Union Pacific (UNP) is a stock that has been getting beat up by the market lately. It pulled back to about $101 today, and let’s say I was comfortable with owning shares at $99.

I could sell a cash secured put, and collect the following premium:

UNP MAY 22 2015 99 PUT
0.34

So, for 1 contract, that’s 100 shares, or $34 premium I would collect with this option. On expiration on May 22, if UNP is trading below $99, the shares will be assigned to me.

Since I was comfortable enough with purchasing UNP shares at $99/share, or $9,900 total, by utilizing cash secured puts, I would be able to pick them up at $9,900 – $34 (premium) = $9,866.

$98.66/share, so slightly discounted. Of course if you have enough funds to execute more than 1 contract, you could conceivably reduce costs further.

In general, covered calls and cash secured puts are regarded as the safest way to trade options since you are executing transactions that you would otherwise do anyway. In my case, I won’t write calls or puts unless I’m comfortable with selling or buying a stock at a particular strike price. I treat the premium as a “dividend payout”. So, in either case, I’m ok with the options being exercised, or expiring worthless.

Either way, I collect the premium 🙂

Cheers!

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13 Nuno May 14, 2015 at 11:15 am

Thanks! It is really good to have all that options on trading options 🙂

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14 Income Surfer May 16, 2015 at 4:42 am

Glad your feed is back up and running. I agree that plenty of investors have unrealistic expectations for the stock market. Some, including my family, seem to have very short memories when it comes to corrections/crashes. As heavily leveraged as you are, it’s probably good you’re taking steps to protect yourself.
-Bryan

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15 DivHut May 16, 2015 at 8:03 pm

As you stated this is clearly not a popular theme among long term dividend growth investors as we seemingly never sell out any position. But I can understand where you are coming from being burdened by such a large debt load among your real estate holdings. It can be scary when a portfolio drops in price dramatically and getting credit/loans can be tough. I guess, since I have no debt I feel comfortable holding each position in my portfolio no matter where the market heads. Will be interesting to see when you jump back in the market in earnest.

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16 Gen Y Finance Guy May 19, 2015 at 7:20 am

Hey man,

I am a big advocate of selling options, specifically covered calls and cash secured puts. As you have probably realized the low volatility market leaves very little premium to extract from the market.

Since price and volatility have an inverse relationship, I would recommend that when you get to a point to sell puts to do it on down days to get extra juice just because it happens to be a down day.

With respect to your call sells, I would recommend going out 30-90 days in order to get more premium. The closer you are to expiration the less extrinsic value an option has. And really the last 15 days or so are basically not even worth selling the options.

Were the prices you shared before or after commissions?

I don’t know what your commission structure is, but I would also recommend that you get hooked up with a broker or negotiate with your current broker a deal to sell options with no ticket minimums. For example, I can buy and sell options for $0.75/contract with no base charge. So if I sell a put it only costs me $0.75.

A lot of brokerages charge a base rate of $4.95 to as high as $9.95 plus a per contract fee. Most people don’t realize that this is negotiable. Just wanted to give you a heads up, because I hate seeing people get eaten up by fees.

If you ever want to talk options, give me a haller.

Cheers!

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17 FI Fighter May 19, 2015 at 8:24 am

Gen Y,

Thanks for the tips my friend! I’m new with this and just executed a few close to expiration calls to test the waters, so to speak.

I did notice much higher premiums further out from expiration, so I will need to figure out where my sweet spot is.

Yup, my strategy will be to write puts on down days and calls on up days… This can help me push out the strike price and since I’m trading dividend growth stocks, I’m fine whether the options get exercised or not.

The prices were after commission which take a big chunk out of the premium since I was only trading 1 contract… But nonetheless, a good learning experience.

I will need to negotiate the base charge, the $4.95 takes a big bite out of the profits!

All the best!

Reply

18 joe kim August 22, 2015 at 9:52 am

Congrats….you’re prediction has been true for this whole month of August but really came true this past friday!

I only had 33% of portfolio converted to cash but then slowly buying back in August which was a mistake…should have waited a little more.

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