Palisade Research - Mon, Mar 5, 2018

Using Optionality to Hedge and Secure My Girlfriend's Severance

image of a girl walking barefoot on a shoreline towards a lighthouse with blackbirds flying around

I was sitting on the couch reading a new book.

It was 5 p.m.

I could hear high-heels clacking off the ground from outside getting closer.

The door swings open.

"Mortgage rates are soaring," she said.

My girlfriend works as a mortgage underwriter for a large bank. Her job is to review an individual's information and approve or decline them for a new home loan or refinancing.

Being contrarians and believing since 2010 the US has been in a debt and refinance bubble - we knew this was coming.

It's always been a question of when - not if.

"I know - I saw on Bloomberg that refinancing's are at a near decade low," I said.

"Not just that - corporate just fired 150 employees today," she said.

We sat on the couch for a while longer and talked about what was going on.

Thankfully we hedged ourselves in a unique way months earlier. . .

Long time readers know how important our investing and life rules are, but especially these two:

  • Don't put yourself in a fragile position - when just a small spurt of volatility can ruin everything.

  • Set yourself up to gain from disorder - make the volatility work for you, not against you.

My girlfriend and I know that her line of work is cyclical.

That's because during years of low interest rates, mortgage lenders do very well.

But when rates start rising, the housing market busts and the lenders suffer. . .

People that are locked into 30-year mortgages at 3.5% won't refinance at 5%, and the decline in new mortgages means lower home sales - which will push real estate prices down.

And since 2017, as rates started climbing, we knew that the housing sector was going to weaken.

"An increase in U.S. mortgage interest rates is throwing ice water on the great American refi — and choking off business for lenders. Refinancings as a share of home loan applications fell to 41.8 percent last week. With a couple of exceptions, that's the lowest level since the financial crisis in 2008, according to data from the Mortgage Bankers Association." - Bloomberg (March 1, 2018).

That's when I had the idea to hedge ourselves in this creative way.

Let me explain. . .

The chances are high that another 2008-like Recession will happen eventually.

Which means there's a huge possibility that my girlfriend might get laid off when that happens. . .

If that situation is likely - why not set ourselves up to get an 'indirect' severance from the company?

That's why in December 2017 I decided to buy her 1-Year, Out-of-the-Money, Put Options on these two housing stocks. . .

KB Homes (NYSE: KBH) and Toll Brothers Inc (NYSE:TOL)

Remember: buying Puts means that the lower their share prices fall - the more valuable they become.

Just like when you're shorting a stock. . .

And so far in 2018 - it's working.

Pain for home construction stocks are just getting started. . .

line chart of symbols KBH and TOL down 16.47% and 12.88% so far in 2018

I don't have anything against these two companies - I just know that a falling tide lowers all boats.

And as the housing market weakens, my girlfriends chance of being laid off increases.

Instead of getting let go and left with nothing, we're hedging ourselves - putting things in our control.

The gains from the Put Options are her 'indirect' severance package.

Clever, right?

We get out from being in a fragile position - breaking from disorder - and into an anti-fragile position - profiting from disorder.

This way if rates keep rising or the economy slides into a recession - she's protected and actually profits from being laid off. . .

But what if the housing sector instead booms and her business actually expands? All that's lost are the small premiums for the 1-year options.

Think of it like when you buy car insurance - hopefully you never have to use it, but if there ever is an accident - your expenses are more than covered.

Our Put-strategy is like paying one time per-year for insurance against my girlfriend's business going bankrupt.

The more the housing sector suffers, the more her potential 'severance' is worth.

Imagine if realtors and home construction employees thought about this in 2006. . .

I'm not saying you have to replicate this exact strategy. But just make sure you do whatever you can to prevent yourself from being fragile.

The bones of this strategy are universal to cyclical sectors. For example, if you work at a Ford dealership, then maybe buying 1-year Put Options on Ford stock would be worthwhile.

This is the kind of creative optionality I look for - a little economic theory, research, and imagination can work financial wonders.

Our readers need to always put themselves in positions to not only survive volatility, but benefit from it.

I'll have more asymmetric opportunities (low risk - high reward) like this coming up on how to avoid being fragile and how to hedge yourself. publishes interesting contributor articles in addition to its own content. We have not verified any of the above details.

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