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Hedging: Ease pain of an energy slide

The classic definition of a hedge is an investment that offsets the risk in another security, ROB CARRICK writes

The curse of investors who have made a killing on oil is to worry that every dip in the commodity's price will send their portfolios down a slippery slope to ruin.

One option for people who have done well with oil stocks or energy and resource funds is to realize some profits by selling a portion of their holdings. But taking too much money off the table means you're at risk of missing out if oil breaks out of its current low $60 (U.S.) range and rises to $70 or $80 a barrel. If you find yourself in this sort of quandary, a hedging strategy might just be the answer.

The classic definition of a hedge is an investment that offsets the risk in another security. With the help of the people at Calgary's McLean & Partners Wealth Management, we'll look at three different hedging strategies you can follow to lessen the danger to your portfolio should oil prices fall.

The first, and most dangerous right now, is to short the S&P/TSX capped energy index, which is dominated by big oil companies such as Encana Corp., Imperial Oil Ltd., Shell Canada Ltd., Suncor Energy Inc. and Canadian Natural Resources Ltd. Short selling is a way to profit from a decline in the price of a stock. In this case, a drop in the price of oil would be reflected in the price of oil stocks and thus in TSX's energy index.

The way to play the energy index is through the iUnits S&P/TSX Capped Energy Index Fund, or iEnergy. Just tell your broker you want to short this ETF and you'll be provided with some borrowed shares that you'll immediately sell. When the price of the ETF falls, you can buy the shares back to cover your short sale, then pocket the difference between your sell and buy prices.

The danger with short selling at any time is that the price of the stock you're betting against could rise, thereby putting you in a position to lose money when you cover your short sale. Your losses are theoretically infinite because there's no limit on how high a stock can rise.

This brings us back to oil prices. They've shown no sign of slowing down, which is why Kevin Dehod of McLean Partners is wary of suggesting investors short the energy index right now. "There's a tremendous amount of speculation, momentum and uncertainty in oil prices, and that creates a dangerous environment for a short," said Mr. Dehod, a vice-president and director at the firm.

An option strategy can also protect your oil profits, though there's a level of complexity here that will be daunting for some investors. By purchasing a put option on the iEnergy ETF, you put yourself in a position to get rid of your shares at a predetermined floor price while enjoying unlimited upside.

Here's an example prepared by Ric Palombi, a portfolio manager at McLean & Partners. Imagine that you own 500 iEnergy units that have run up sharply since you bought them a year or so ago. The units are now trading at a hypothetical $78.28 and you decide you lock in a $76 floor price over the next five or so months by purchasing a put option that expires in December at a quoted price of $3.30 per contract. Put options give you the right to sell shares at a certain level, while call options offer the right to buy.

A contract represents 100 shares in the underlying stock, or ETF in this case, so you'd need to buy five contracts. To get the actual purchase cost of a contract, you have to multiply by 100. So one contract would cost $330 and five would cost $1,650 before commissions, or a little more than 4 per cent of the value of your iEnergy holdings.

The cost of buying put options can be pricey, especially if the underlying stock or index involved is highly volatile. "But if you're up 100 per cent, maybe you don't mind giving back 3 or 4 per cent," Mr. Palombi said.

There's a way to reduce your portfolio insurance costs using options, but the tradeoff is that you have to lock in both a floor price and a ceiling that will cap your potential gains at a certain level. This strategy is called a collar and it involves purchasing a put option -- that's where the downside protection comes in -- and at the same time selling a call option that will allow someone else to buy your shares at a set price.

Mr. Palombi's example: You own some shares of Canadian Natural Resources, now trading at a hypothetical $57.81, and you decide to set a $54 floor price by purchasing a January, 2005, put option for $3.50 per contract. You could stop there, but the cost of your downside protection would be a stiff 6 per cent of your holding in Canadian Natural Resources.

To offset this, you could sell a January, 2006, call option pegged to a price of $62 for Canadian Natural Resources. This would bring you a contract premium of $4 a share that cancels out the cost of buying the put options and even brings in net proceeds of 50 cents per contract. The only drawback is that you won't benefit if this stock moves past $62.

The easiest way to build some protection into an oil-heavy portfolio is to own shares, exchange-traded funds or mutual funds focusing on sectors that don't follow the ups and downs of crude oil prices.

Mr. Dehod said a classic example of a sector that works well as an oil hedge is health care. There isn't much of a selection of publicly traded health care companies in Canada, so he suggests looking at either the half-dozen or so ETFs that track U.S. and global health care stock indexes, or at blue-chip companies such as Johnson & Johnson and Becton Dickinson. Both are stocks that are used in the portfolios that McLean & Partners designs for its clients, in part because both have exemplary records for regularly increasing their dividends.

Industrial stocks are somewhat more tied to oil prices, but they're independent enough to offer some hedging potential. Names suggested by Mr. Dehod include Canadian National Railway and Finning International, which sells and rents construction equipment in Western Canada, Britain and parts of South America. Finning is benefiting from all the building going on in the Alberta oil sands right now, but it's diversified in that it's also involved in road building.

Like health care, consumer staples are an obvious place to look for stocks that are not held hostage to oil prices. Mr. Dehod points out that there's an additional benefit with this sector in that it would offer some shelter if the broader stock market slumped. "It's a real contrarian play right now," he said. "You may not make money for a couple of months while this energy thing continues to go crazy, but it's a nice sector to accumulate and build some positions."

The favourite consumer staple stock at McLean & Partners is Loblaw Cos., but Mr. Dehod said Shoppers Drug Mart Corp. and Alimentation Couche-Tard Inc. are also possibilities. Internationally, British grocer Tesco PLC is a stock you can purchase on the U.S. market as an American Depositary Receipt.

McLean & Partners clients average about 14-per-cent exposure to oil, which is offset by a weighting of 9 per cent or so in health care and consumer staples. The people who use hedging strategies tend to be those who have accumulated a big position in a single company, maybe because they were an employee there who received stock options or through successful speculating in the stock market.

"People often don't want to sell because they get married to their winners," Mr. Dehod said. "But they're also uncomfortable or can't sleep at night. So what do they do?"

One answer is to hedge, even if it only means buying some Loblaw shares.

When oil stops boiling

Investors with lots of exposure to oil in their portfolios can protect themselves by diversifying into sectors that have a proven ability to hold their own when oil prices decline. Here are some examples:

HEALTH CARE

Stocks to look at: Johnson & Johnson (JNJ-NYSE), Becton Dickinson (BDX-NYSE)

Exchange-traded funds to look at: Select Sector SPDR-Health Care (XLV-Amex), Vanguard Health Care VIPERs (VHT-Amex), iShares Dow Jones US Healthcare (IYH-Amex), iShares S&P Global Healthcare Sector (IXJ-Amex)

Mutual funds to look at: There are 20 or so health-care sector funds - details can be found on Globefund.com

CONSUMER STAPLES

Stocks to look at: Loblaw Cos. (L-TSX), Alimentation Couche-Tard (ATD.SV.B-TSX), Shoppers Drug Mart (SC-TSX), Tesco PLC (TSCDY on the U.S. over-the-counter market)

Exchange-traded funds to look at: Select Sector SPDR-Consumer Staples (XLP-Amex), Vanguard Consumer Staples VIPERs (VDC-Amex), iShares Dow Jones US Consumer Goods Sector Index Fund (IYK-Amex)

INDUSTRIALS

Stocks to look at: Canadian National Railways (CNR-TSX), Finning International (FTT-TSX)

Exchange-traded funds to look at: Select Sector SPDR-Industrial (XLI-Amex), Vanguard Industrials VIPERs (VIS-Amex), iShares Dow Jones US Industrial (IYJ-Amex)

© 2007 The Globe and Mail. All rights reserved.

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