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I have liquidated my entire portfolio. I now have cash, earning low interest with tax. I want to build back my position, but am waiting for the right time in the market, likely higher interest rates. I am happy to wait a few years if necessary.

My only worry is inflation. If the markets keep rising, I don't want to miss out. I am trying to put together a small portfolio of insurance in case the markets keep rising, or inflation gets too high, and my cash loses too much value.

My current thought was to pick some stocks that would likely rise much higher in the market than others, if the economy keeps thriving, I was thinking possible banks, or stocks with higher BETA's than others.

With this portfolio, perhaps of around 5 stocks, I would then buy long term call options, perhaps 12 months out, and as to make them not too expensive, perhaps out the money, with a strike price about 15% higher than the market price, or maybe even a combination of 10-30% above strike price.

That way if the markets increase dramatically over the next year, my money, although not worth as much, will be made up for on the increase in value of the derivatives.

What are your thoughts on this technique? Does anyone else have any other ideas on how to protect against inflation like this?

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    This is a very advanced form of trying to time the market (something generally advised against, particularly on this site but also generally, especially for amateur investors). From the context of the question I suggest that you may be in over your head here, and you should heavily consider doing something that requires less of an active participation in the market. – Grade 'Eh' Bacon May 15 '18 at 21:02
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    You're right, the OP may be in over his head but how is the he going to climb the food chain and get an idea of various approaches to his problem if he doesn't ask and then receive feedback? – Bob Baerker May 16 '18 at 1:02
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What perplexes me is that you have liquidated your portfolio due to perhaps over value of the market (?) and you are willing to wait a few years to reacquire it but you want to build it back up now to some extent because of inflation fears. It seems like a bit of a mixed message. Be that as it may...

To ward off inflation, you could short interest rate sensitive securities or buy inverse Treasury ETFs. I'll leave it at that since these are for experienced investors/traders.

Conventional wisdom is that commodities, gold, real estate, oil, inflation-indexed bonds (TIPS), REITs, floating rate preferred stocks, and to some degree stocks, are hedges against inflation. But that's simplistic because they don't always correlate. Rather than go in that direction, let me just address the derivatives you mentioned.

Your suggestion of buying call LEAPs 15% OTM on high beta stocks isn't a terrible idea but it has several problems I don't like:

  1. On an expiration basis, the stock will have to rise up to the strike price (15%) plus the premium paid in order to break even. Share price increase before expiration may make money sooner but what that amount might be is time and price dependent and can only be estimated by using an option modeling software on the web or from your broker.

  2. Buying 30% OTM is more of a lottery pick and you'll need to have some really good stock pickability to overcome that

  3. High beta stocks tend to have much higher premiums so you will pay more dearly for options on them. That's not a problem if your picks work out well - just a larger obstacle to overcome and a larger loss if they don't work out.

Make sure to factor dividends into your calculations because share price is reduced by that amount on the ex-div date and while that reduces the cost of a call, it increases the amount that the underlying must rise to achieve a gain or break even.

Another consideration might be using high delta call LEAPs (1-2 years out) as a surrogate for long stock. The call LEAP cost is much less than the stock, you'll pay a much more modest amount of time premium (assuming they are not high beta/high IV) and the theta decay is almost non existent early on. On a one to one basis, if the market tanks, they have less risk than the underlying. You can Google "Stock Replacement Strategy" for more info.

If so inclined, you can also write OTM short calls against them, turning your long call LEAPs into diagonal spreads and lowering your cost basis. This is called the "Poor Man's Covered Call" which you can also Google.

The problem with the Stock Replacement Strategy and the PMCC is that you might have more exposure than you currently want, given that you liquidated everything. If you want to participate in to the upside, you have to be in it to win it which I'm not sure that you want to do (the liquidation).

Another way to generate some yield could be to sell OTM puts on stocks that you would be happy to own at lower prices. Look at 30-45 days out to maximize theta decay and ROI though sometimes, ROI for 2-3 months is almost equivalent. In this period of relatively low volatility, you won't get much premium but if all works well, you'll have a steady income exceeding the yield on your cash in the bank. If not, you'll acquire quality stocks (or ETFs) that you are willing to own at lower prices.

  • Thanks Bob, if the market tanks, I accept that this portfolio can be a write off. It would only be a fraction of my cash, and is merely an insurance policy so I dont "miss out". In reality I am betting on the market tanking, or interest rates rising, if this occurs my cash is effectively more valuable. So I would want to invest in a growing economy with minimal rate rises, and if this doesnt occur, losing said investment is acceptable. – Source May 16 '18 at 7:00
  • Hypothetical example with rounded off numbers for ease of description. AAPL is $187. 15% OTM call at $215 strike one year out costs $4. Expiration break even is $219. 30% OTM call at $245 strike one year out costs $1. Expiration break even is $246. That's an awful lot of upside movement needed to break even so I wouldn't really call such positions participating in the upside or hedging against interest rate increases. You're just making a long shot bet hoping that the underlying makes a big move, allowing the leverage to kick in. – Bob Baerker May 16 '18 at 11:23
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You might be over-complicating this, since I believe your question can be reduced to simply:

I have some money to invest. How can I minimize risk while keeping up with inflation, and also keep my funds liquid enough that I can switch to higher risk investments in the near future?

To minimize risk, your target return should be your specified minimum requirement, which is the current rate of inflation. In most cases (though country dependent) targeting the rate of inflation is considered a conservative investment and should be easy to accomplish. For example, in the US, high yield savings accounts, CD's, and highly rated bonds should get you close or even better than the current rate of inflation (about 2%). In other words, there's no reason to mess around with stocks or options if your goal is only to beat inflation.

  • No, I dont want to lose money, if interest rates increase, all those assets drop in value. I am looking for more of an insurance policy, where if things go very wrong for me I can cash in, but if not, then I can write off the policy. – Source May 16 '18 at 6:51
  • @Source - you don't lose value unless the rate of inflation increases above your rate of return, regardless of where rates go. Furthermore, when rates increase, your (staggered to increase liquidity) CDs and high yield savings accounts rates increase along with it. As opposed to your insurance policy, where you definitely lose money whenever you have to write off the policy. – TTT May 16 '18 at 10:29
  • Core inflation currently exceeds high yield savings accounts and a one year CD is about a wash. The only way to yield higher with these is a longer term CD and being locked in as rates rise is counterproductive. – Bob Baerker May 16 '18 at 11:37
  • @BobBaerker - I agree. Since inflation is gradual after rate increases there should be plenty of time to keep up, even with long term CDs, though you could also stagger CD terms to balance it even more. But I think the key point is the desired strategy of OP is to simply keep up with inflation and not necessarily strive to "yield higher" than it (at least until it's "time" to do so). – TTT May 16 '18 at 12:29
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    Perhaps a better way of phrasing it is that you want to participate in (not hedge against) the economy improving. That means owning long positions As for inflation, if it rears its head, don't you think that the Fed will raise interest rates to slow it down? If so, then you buy securities that perform well or keep pace with higher rates or you short securities or buy puts or inverse ETFs on those that suffer from it. – Bob Baerker May 16 '18 at 18:55
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Which country are you from? Here, in India, even bank fixed deposits (7%) give higher return that inflation (4-5%).

When the market goes up and I cash in my profits, I put the cash in fixed deposits and wait for the next market crash.

Maybe you can find something similar in your country.

Of course, if you know what you are doing, then you can try the more complex instruments.

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