Peterson Investment Fund I

Peterson Capital Management, LLC

HEDGE IMPLEMENTATION
Because we accept the unknowable and recognize our inability to time the
market cycle, we have determined it prudent to incorporate the following
multi-year value-based hedge that provides nearly three years of rolling
portfolio protection. This hedge will cause a 1% headwind during a flat and
rising market, but it will provide considerable protection and gains during a
recession and market meltdown. Building the hedge requires three years of
planning, and 2018 concluded the second year. The world may continue on an
upward economic trajectory for a number of years, but when the cycle turns,
we will be prepared.

The Black-Scholes option pricing model is highly dependent on the price of

the underlying position and its volatility. As equity prices climb, put prices
decline and when volatility is low, put prices decline as well. Thus, we have
found that multi-year put contracts on the S&P 500 index are very inexpensive
when volatility is extremely low.

First-level thinking allows us to understand the value of owning some out-of-

the-money puts against our equity portfolio. Second-level thinking helps us to
understand that we do not need to hedge this position to zero. As value
investors, we become interested buyers of the market after some level of
correction.

Having analyzed decades of bear market declines and intra-year drawdowns,

we have determined a rational willingness to buy the market after a 35%
market decline. So, we designed a three-legged structured product that
provides 10x downside protection through 2020 in the event that markets
decline by 35%.

Technically, with low volatility, each year we buy a long-duration, slightly out-
of-the-money put and sell two offsetting far out-of-the-money puts to help
pay for the hedge. This means that, by allocating 1% of our portfolio to this
hedge, we can achieve a 10% portfolio gain if we happen to head into a
recession over the next three years.
Last year, we indicated this hedge will be held until contract expirations.
However, there is a caveat: we will unwind this hedge early if its market value is
at or near its maximum potential value.

The graph (next page) illustrates that our payout has a maximum value of
approximately $95 (over 10 times the net purchase price of $9) should the S&P
500 decline to between 1,700 and 1,900. Historically, many major corrections
reach this percentage decline. In the future, if this hedge has appreciated to a
combined price near the maximum, we are likely to unwind the components,
prior to expiration. A net price of over $80 will be of interest, earning nearly 9
times our cost of $9 for this protection.
 UNDERVALUED PORTFOLIO HEDGE DETAIL

Trade Leg Expiration Product Buy/Sell Strike Price

Leg 1 Dec 2019 Put Buy 220 13.5

Leg 2 Dec 2019 Put Sell 170 4.5
Leg 3 Dec 2019 Put Sell 160 3.5
Leg 4 Dec 2020 Put Buy 275 21.5
Leg 5 Dec 2020 Put Sell 200 9
Leg 6 Dec 2020 Put Sell 190 9
Trade Cost 8.7

UNDERVALUED PUT SPREAD HEDGE PAYOUT PER CONTRACT

Please note that this in no way suggests that we will not experience our own
volatility. But, this hedge allows us further comfort in holding our long portfolio
and we can sleep well at night. As Howard Marks has quipped, “You can’t
predict. You can prepare.” It would be interesting to hear Ed Thorp’s thoughts
on our appropriately sized, inexpensive, portfolio hedging strategy.
Peterson Capital Management, LLC
222 North Pacific Coast Highway
Suite 2000, El Segundo, CA 90245
www.petersonfunds.com