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Hedging part 5. leveraged ETFs + hedging with options = winning in both directions?

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March 24, 2009 – Comments (2)

This blog is entered this afternoon with the intent of having a small discussion with myself about the possibility that one could create a strategy that wins in both directions of the market.  There's no doubt that you would have gains that were less extreme down and less extreme up than simply shorting or being long (respectively) but its not hard to see the value in such a strategy.

Julian Roberton issued one of my all time favorite quotes about the stock market once, and its reported to have gone a little something like this:

""Our mandate is to find the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and go short on them. If the 200 best don't do better than the 200 worst, you should probably be in another business."

I like that... alot.  Its truly market neutral, which doesn't mean he couldn't lose.  In fact he could lose big if he shorted the wrong 200 companies, etc.  But its market neutral, it takes Ben Grahams "Mr. Market" out of the equation. 

Most successful long term investors have made their money by taking advantage of Mr. Market.  Mr. Market, for those who don't know, is how Graham described the wild and often irrational volatility in the stock market.  He suggested that at times a good company that is worth, for example, $40, will be priced at $50.  This is when the market is in the throws of a bull run and everybody is happy.  At other times it will be priced at $30, for example when the market is bearish and afraid like now.  David Dreman and Warren Buffet and many (most?) other investors that have been very successful over long periods of time have played by these basic rules, buying companies that are out of favor and cheap and waititng for them to come back in favor. 

But Robertsons quote above hints at a strategy that works to ignore Mr. Market completely and make money based on ones own ability to assess value of companies or prospects of companies (and currency, and commodities, etc.). 

Today, and for the last few months, Mr. Market has been working for value investors like my modest self pretty hard, handing us shares of good companies for 2x, 3x, even 10x lower than their previous highs.  And in the last few weeks Mr. Market has been rallying, giving people ilke me who were very long at the bottom very, very good returns in a very short period of time.

Since my portfolio turned green and then ultra green, I've been thinking alot about hedging... taking the edge off of downturns in the market.  One can hedge in many ways including selling covered calls (see some of my other march 2009 blogs), buying puts (which go up when the underlying securities go down) on stocks I own, and on the broad indexes, and on financial sector ETFs (i'm heavily weighted in insurance and financials right now). 

Today I want to talk (although maybe not in this opening post) about hedging in another way, and that is hedging by buying puts on the levered Bull ETFs.  I'd like to crunch some numbers and estimate if there is a way for my portfolio to actually win in both directions from here, and/or if my downside can be limited much more drastically than my upside is hampered. 

A levered ETF has a couple of traits that make it particularily suited for this kind of use.  They are

1.  The levered ETFs volatility is by far greater than the market or a sector of the market itself.  If the S&P drops 1%, SSO may drop 2%.  If the financials rise 10%, FAZ may drop 20 or even 30%.  this gets you more bang for your buck, in theory, with the hedging effect of buying options.  That in turn reduces the amount of cash you have to put into the options, lowering your downside on upswings or if your options expire worthless due to an ongoing rally.

2.  they intrinsically decay in value over time.  The levered ETFs decay somewhat over time, some more than others, and this, all other things equal, works to increase the value of the put options I propose to buy.  It helps the downside, and to make money on the puts you need downside...

My portfolio is quite volatile, having a generally very high beta (ASH, RCL, XL, GNW, HIG, AFL, MET, WFC, BAC, BX, ACAS, ALD, GE, OSK are among my larger holdings,a ll of those are high beta stocks!) and that makes the upside to a good quality hedge pretty strong.

A real downside to using optiosn as hedges (except the sale of covered calls, in that case this is a GOOD thing) is that their value decays, all other things equal, with time. 

Let me start my exploration by just wandering through one scenario loosely:

i own $1000 of SPY, which tracks the S&P 500. 

I hedge that with $100 worth of puts on SSO @ $21 strike price for april.  Those cost about $1.70 each. 

By april 17th, the S&P has hit 700 so SPY is 70, a loss of 14% from todays levels (thats bad, and costs me $140 out of my $1000 investment in SPY).  But my puts at that time are worth about $5.50 each.  So my $100 investment in SSO puts as a hedge would be worth about $320.  So i would, net, be up $180.  Sweet! I can then close out my hedge and ride the wave back up if I'm sure that the market is heading up from there, or I can take another hedge to shelter from downside again.  In this scenario, it worked really well.

But what if the market goes up?  Lets say the market rallies to 900, or up about 10% from here.  Then my $1000 of SPY would be worth $1100.  But my SSO puts would be worth $0.  So in that case I'd break even despite the market being up.  Thats no fun.

So in this case, perhasp the best all around hedge would be about $50 of SSO puts.  If the market took the bearish case above, I'd still win, but slightly.  If the market went bullish I'd still win, but not as much as I would if I'd have simply been long.

This analysis was brief, inadequate, and hardly worth concluding over, but it shows promise... 

2 Comments – Post Your Own

#1) On March 24, 2009 at 4:19 PM, checklist34 (99.69) wrote:

Properly applied discretion, of course, could result in a hedging strategy like this becoming much more effective than whats shown above.

For example, imagine this scenario:

like above, long $1000 of SPY

like above, long $100 of SSO $21 puts. 

The market crashes to 750, but I decide thats low enough and make a play for a rally to come.

So I sell the hedge, which at that time should be worth about $3.25-3.50.  My portfolio is down $75, but my hedge is up $90-100 or so, leaving me up 25 or so (this is all really lazy rough math). 

So then I go pure long with no hedge, and the market rallies to 815 again.  So SPY is even...  but I'm up $100.  up $25 on the hedge and up $75 on the return trip.

Nice!  This looks like a strategy that has alot of potential!  But...  It'll probably take a couple weeks of digging through how options tend to behave and staring at charts and making spreadsheets to really get a system that works. 

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#2) On March 24, 2009 at 4:31 PM, checklist34 (99.69) wrote:

The way you'd lose on a situation like I described above is if you held the option to expiration and the market didn't move significantly.  For example if SPY stayed the same every day , my options would be worth about $0.50 when they expired and I'd ahve lost money despite the S&P moving. 

So this, unlike the covered call which remains my favorite option strategy for hedging, has a downside. 

Still, for this market, moves like this even if to only partially hedge oneself against downward movements when you are predominantly long, should have some value.  So far since I started trying it the market has been predominantly up, so its likely that I've netted a loss on my options. 

But that loss is worth about 40% or 30% or whatever as a tax write off... 

Options are fun!  Some of my fine fellow fools would do well by themselves to spend more time exploring things they CAN control, and less time doom and glooming and wishign for everything to go to crap in a handbasket so they can be "right".  And, maybe, make money on their shorts. 

Today I was up on a down day in real life, thats a fun time!  Not up much mind you, but a percent or so, and thats not nothing!  The hedges I've taken so far were worth about 1/2 of that percent (very rough figures). 

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