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Whats the best hedging strategy?



March 13, 2009 – Comments (8) | RELATED TICKERS: SPY , RCL , BAC

Well my big bet from last week and earlier this week on has paid off pretty handsomely and my portfolio finished the week up almost 30%, and i'm not up overall by almost 20% ... with no short term profits to pay taxes on, since I started making my own investing decisions in December. 

My profssionally managed money is beating the S&P, but it is down over the same time period.

And now, after 4 days of strength and a big rally, I'm interested in hedging against losses if the market dips down again. 

I'm also concerned that Q1 earnings might be ugly, and that the market might come back under pressure during Q1 earnings season.  I absolutely positively make no claim to being good at forcasting short term market moves, but its possible for me to envision a positive bullish market for a few weeks here turning bearish when Q1 earnings season kicks off.  And i think that (the end of Q1 earnings season) may well be the end of this amazing bear market. 

So i'm interested in hedging my current gains against losses while staying generally very long the market.  I'm curious what my fine fellow fools consider the best overall hedging strategy?

These come to mind:

1.  take some profits and sit on more cash than I have right now.  This would reduce my portfolios volatility both to the up and down sides.  This is a prudent step ahead of an earnings season that might bring some pain...  And it gives me the ability to place larger bets on stocks that I like but which might dip during earnings season. 

2.  short the market or individual stocks.  This could in theory lock me in to current profit levels for a period of time, or if I partially shorted my portfolio or shorted the index it could be a partial hedge against movements.  What I don' tlike about shorting stocks is A) right now the market is still incredibly oversold and I think shorting a market thats at these levels is risky business.  Also B) there's no limit to your downside with a short, but there's a big limit to your upside. 

3.  Buying puts on the broad index or individual stocks (SPY, maybe GE or BAC).  This i like much more than shorting things.  If you buy a put on SPY and the market drops, the value of that put can lurch up far, far more than the drop in the market.  The same applies to it losing value if the market rises.  But the total downside of the put hedge is perhaps 80% of the cost of the puts as they won't go to zero and if the market turns bullish during earnigns season I can always dump them when I don't feel worried about Q1 earnings...  The risk/reward here seems good, frankly, the only problem would be if the S&P went up, but my stocks went down, in which case I'd ahve a double whammy.  This would be alleviated if I could get puts on my specific stocks of course, but there isn't alot of put volume for some of them.

4.  Selling calls against my portfolio at prices I can't refuse.  I own alot of RCL which i'm up on.  :)  If there's any volume of options for RCL I could sell say $10 or $15 calls reaching out a few months.  If those stocks drop, the value of the calls drops and I can buy them back at a profit, partially compensating me for loss in the stock.  This could work provided there's any money in the calls at prices I would be happy to sell for and provided that theres any volume of options in the tickers I own.  There's no real downside risk here if the calls you sell are at prices you are satisfied with.  But its not likely that this will lead to a high percentage of hedging... 

5.  going long on something thats inversely related to the market.  gold maybe, gov't bonds maybe...  I don't like those ideas as gold is still overpriced IMO and bonds are still really badly elevated.  But i'm not above doing some of these things...

Anything I'm missing?  Buying puts and selling calls seems to be the best overall strategy...  Or am I somehow not seeing the bigger picture?

8 Comments – Post Your Own

#1) On March 13, 2009 at 10:02 PM, TMEBenBenBen (< 20) wrote:

--If you are looking for a hedge with low correlation to equities consider looking into LSC.

LSC is a convenient rules based commodities hedge in the form of an ETN (you need to be comfortable with holding HSBC unsecured debt).  Basically it allots fixed percentages for sector exposure to Energy, Livesotck, Base Metals, Prescious Metals, Grains and Softs (sugar, cocoa, coffee, and cotton.  The Fund goes long when the price of the sector exceeds the 7 months exponential average, and short (or flat in the case of energy) when the price is below the 7 month exponential average.

Performance is decent, expenses are not outrageous, and correlation to equities is very low.


--As far as hedging against the inevitable continuation of the downward trajectory... If you can find the shares to short the 2x or 3x  leveraged Bull funds, there are some strong advantages there to consider.  If you cannot find the shares, puts on the levereaged bull funds might be something to consider.


----You can also consider going long volatitly with VXX, if things crash and volatility goes throught the roof, you should see some strong returns on VXX (you need to be comortable holging Barclays unsecured debt if you are going to use this ETN).


I hope I have proposed some potential ideas you can consider for further investigation.

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#2) On March 13, 2009 at 10:20 PM, checklist34 (98.69) wrote:

Thanks Ben, ... i could also go long on a 2x or 3x leveraged Bear fund.  Thats a great idea...  Potentially more hedge for dips with less risk of capital.

Over the long term the only thing I think is inevitable is the market going up...  but I am worried about the Q1 period and another bloody run by wall street. 

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#3) On March 13, 2009 at 10:33 PM, anchak (99.91) wrote:

Ben.....LSC was a great idea - however it essentially is a MA-crossover Long-Short strategy with commodities. Great for a lot of investors - but may not be desirable for checklist - because he seems to be looking for a hedge right now. Of course - if you want to leave it to other people to make your exit/entry - its great.

The VXX ( or a long on VIX-W options) is a great thought ( I am currently playing this).

(2) I disagree with this - yes it is true from a pure mathematical standpoint. However - it boils down to your exposure ( because it will be a factor of it ie are you shorting $1000 or $10000 in realtion to your portfolio). Additionally, you should round up some real laggards ( eg LVS) and other which shot up in the rally and short ALL of them - this limits one of them doubling and taking you to the cleaners

(3) is good - but has some shortcomings as you mentioned.

Checklist - you truly seemed to have checked your list - :)

Incidentally, book your portion of your gains - otherwise in all this hedging ( for eg puts) - you might just get stranded

All the best!


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#4) On March 13, 2009 at 10:41 PM, Imperial1964 (94.01) wrote:

I like the idea of Puts fairly well, but only if the options are inexpensive, like when I bought Puts back in September.  But honestly there isn't much difference, in my opinion, between fully hedging with Puts and being all in cash.

The question I want to ask is why specifically are you hedging.  If you define exactly what you are trying to achieve it will probably lead you closer to the answer you are looking for.

For example, if you are afraid your particular stock or stocks will fall you should probably either just sell or buy Puts.  Buying out-of-the-money Puts can help you hedge against large losses without giving up all of your potential gains if the stock goes up.

If you are fraid of an overall market decline, but are confident your stock will hold up better, perhaps you should buy puts on the S&P 500 index (SPY).  If you are 100% hedged at-the-money you will profit from the difference in performance, minus the costs of hedging.

If you are confident in your ability to short stocks, hold your good stocks and short some bad ones.  Just beware: most of the easy short candidates have already been shorted into the ground and there isn't much money left to be made.

Frankly, I'm not a big fan of hedging.  Think about the expense of hedging vs. sticking your cash in an interest bearing account.  If you're uncomfortable remaining unhedged in the market maybe you shouldn't be in the market right now.

Just my 2 cents.

By the way, my Puts in September were speculation, not a hedge.  I sold at the end of the month for a quick double.  If I had held to expiration in October I would have had my money times 12.

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#5) On March 14, 2009 at 4:23 AM, BenGriffin71 (27.67) wrote:


You are spot on.  I should have specified that LSC could be be bought afte taking some profit.  It is a longer term hedge in that it has very low correlation to equities.  Being of low corelation it won't necessarily go up when equities crash... of course it won't necessaruily go down then either.

Checklist.  When you are deciding between

 1. going long the 2x and 3x bear fund ...


2. Buying Puts or shorting the 2x or 3x bull funds...

It is useful to compare the 2x or 3x bull and its corresponding bear in terms of historical returns.    consider what you would have now if you had bought equal dollar amounts of each at 1 month, 2months,  3 months ago.

There are exceptions, but in many cases at 2 months and beyond, you would have significantly less month by going long both.  The leverage and the cost of continually rolling the dirivative errodes these leveraged funds.  If you go long, this works agains you...  If you are short, this will work for you IF....IF.... IF you have enough time.  It is not a no-brainer, and you need to be committed to an exit strategy that protects you from excessive losses, and of course ensures that you lock in any profits.

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#6) On March 14, 2009 at 4:42 PM, checklist34 (98.69) wrote:

anchak, thanks for the input, I appreciate it.  What does "book your portion of your gains" mean?  I may be behind the rest of the class on that one.


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#7) On March 14, 2009 at 4:57 PM, checklist34 (98.69) wrote:


     Those are good points and questions, and I appreciate the input.

     My investment philosophy has been to focus on battered stocks of good companies or severely battered stocks of companies that are likely to survive.  So I own tickers like ASH, RCL, XL, a recent mob of bank BDC and insurance names, OSK, several commodity companies including TCK (bit of risk here for sure, lol), ACI, CHK and others, and some blue chips and cyclicals like USG, AA, DOW, and GE.  Nothing in my portfolio was bought less than 75% from its recent highs and alot of it is 90% or more down.  The basic strategy is David Dremman contrarianism + a bet against a doomsday scenario.  But the fact of the matter is that these picks, while I think they are all very good long term buys from the prices I bought them at, are all high beta names that move rapidly with changes in market sentiment. 

Typically, I drop about 2x as much as the market on a down day, and typically I rally 2-3x sa much.  The days when the market was down and my picks were up outnumber the days when the market was up and my picks were down. 

But the nature of my high beta selections is that if sentiment turns sharply negative again, I will take a substantial penalty, whereas when sentiment gradually turns more positive as the recession slows/ceases, money starts coming back into stocks, etc., I am very confident in these selections, in aggregate, outperforming the market and doing very well over the long haul.

And so i'm interested in mitigating the severity of the penalty should market sentiment turn sharply negative once again.

Those september/october puts ... thats an incredible story.

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#8) On March 14, 2009 at 5:01 PM, checklist34 (98.69) wrote:

Ben, the natural tendency of the leveraged ETFs to decay over time...

Perhaps one could put that to work for you.  Buy puts on the 3x bull ETF, etc..  The decay should work to, all other things equal, enhance the value of the puts over time.  Making the "downside" to the market going up less severe than with some other types of puts.  Just a thought.


Overall, looking closely all afternoon at SPY puts, I'd have to say that the ones that seem to offer the best bang for the buck are ones that are out of the money right now, but not too out.

Say a 71 or 72 put going out a month.  The drop in value of out-of-the-money puts isn't as severe when the market turns up (as they are already really cheap) and the appreciation when the market drops is more aggressive than puts at or in the money.

Thanks man

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