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Hedging or not?


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IMO, the market appears ready for a pull-back. Valuation is no longer that attractive, the dividend yield at around 2% is nothing amazing vs other income instruments and after such a run, people will experience fear very quickly of losing their profits on any sign of weakness. Also, the argument of some investors being late and chasing the S&P performance will disappear after December 31. Finally, on a technical standpoint, the market is completing an almost perfect rounded top since early March.

 

I understand that timing the market is extremely difficult if not a fool's game, but many signs are now present making the market vulnerable. Should it be simply ignored?

 

If not, at the moment, I sit on around 30% cash (looking for ideas) with the rest invested in cheap, relatively small companies. 2008 has thought me that these companies suffer much more in a market debacle, both financially and on a share price standpoint than the S&P. I like the idea of having cash ready to deploy if we have a material pull-back, but I still don't like the idea of seeing my other 70% being decimated. I understand that it should be a temporary "decimation" unless we enter a major depression, but again with all the signs around, should something be done about it?

 

1- Selling everything and waiting does not seem reasonable. Will I be able to buy the same stocks again at their current price? Still at the moment, all my holdings are being scrutinized.  

 

2- Buying S&P at or in the money puts as some have done does not appear very practical to hedge against smaller companies. What if the S&P goes down 10%, but your holdings 30%? You would need a much larger notional amount of S&P puts to offset your losses and then you are talking a major expense with high risk/low reward. I have not found any index that would come close to the kind of things that I own. Even the out of the money S&P puts (high risk/high reward) are not cheap change to hedge against the low odds of calamity.

 

3- Shorting an index is a lower cost alternative to #2 and with similar reward if the index does not go down by a lot, say 10 to 20%, but the exit strategy is crucial.  

 

4- Shorting or buying puts on troubled companies can be very profitable and a good way to hedge losses on small caps. The issue that I see is that this starts to work very well once the market has started to come down. That is when real trouble starts to emerge. They may come down 30% on the initial market weakness, but the next 30 or 50% is the easier money, anyway from my experience. Think of GM, FNM, C and others. They decline first following the market, but after that it becomes obvious that their survival is at stake.

 

5- Loading up on long term treasuries or their derivatives has been a good hedge historically. Unfortunately, if there is no market correction, this stuff could turn toxic with higher interest rates. Also, treasuries may not go up a lot this time around with abundant supply.  

 

6- Gold seems to work well after the debacle not during.

 

What else is there?

 

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Why do you really care if your portfolio takes a temporary dive?  As long as you think that your current securities offer good value, then the market's broader moves are only a temporary distraction.  Do you need the money soon?  If not, you could end up paying a fair bit to buy "insurance" when you might not really need it.

 

For whatever reason, last winter the decline in my portfolio value did not seriously psychologically affect me.  Rather, I was a busy beaver looking for securities that were obviously mis-priced...and I deployed all of my cash.  And then I margined lightly.  I was so preoccupied with  buying stuff, that the last thing that I was worried about were the market values of my existing securities!  If course, I am certain that I will not need even a penny of that stash for at least another five years, so it's easy to ignore the gyrations.

 

From a valuation perspective, I think you are correct that there is more room for the market to go down than up.  I was a great deal more comfortable at S&P500 ~ 800-900 than I am now.  With limited attractive options, I am accumulating cash in a government guaranteed savings account that pays me 0.75%.  It's not much of a return, but I don't want to deploy cash for the pure purpose of deploying cash.....I want to see value first.  When opportunities emerge in the next period of market dislocation, I will be ready!  I will again deploy my cash, and if conditions are particularly attractive, I will again margin lightly.

 

I just need to remind myself not to do anything stupid in an effort to reach for yield.

 

SJ

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I bought more at-the-money SPY puts this morning (boosted the number of contracts by 50%), and yesterday I bought some SPY June 80 puts (notionally hedging 20% of my current net worth).  The goal of this is to be able to buy more without fear after the pullback that I think is coming.  And I'm levered anyhow, the leverage will pay for these puts if the V shaped recovery happens.  My net worth is levered by 30% but at-the-money puts protect 66% of my net worth.

 

So now I will start talking my book and acting really bearish I suppose  ;D

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I bought more at-the-money SPY puts this morning (boosted the number of contracts by 50%), and yesterday I bought some SPY June 80 puts (notionally hedging 20% of my current net worth).  The goal of this is to be able to buy more without fear after the pullback that I think is coming.  And I'm levered anyhow, the leverage will pay for these puts if the V shaped recovery happens.  My net worth is levered by 30% but at-the-money puts protect 66% of my net worth.

 

So now I will start talking my book and acting really bearish I suppose  ;D

 

  "Smarter than the average bear!"

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I am completely unsure of which way things are going.  So I have hedged my holdings to about 40% on a linear basis.  I have used at the money SPY puts (109s, 110s, 111,s).  At the same time I have alot more money in holdings that are paying dividends that are (unlikely?) to be cut.  That could add some stability both in Canada and the US holdings.  Companies such as BCE, PWF, JNJ, KFT, RUS, and leaps on other Blue Chips - FFH, GE, HD. 

 

I have never been able to wrap my head around holding cash except at what I can say for near certainty are market high extremes.  In my estimation we haven't had one of those since 2000.   

 

Taking last fall or winter for example should I have held cash until the following S&P levels:

1) 900 - wouldn't have worked

2) 800 - wouldn't have worked

3) 700 - may have worked - subject to hindsight bias

4) 600 - would have missed the entire upside

5) 500 - same thing.

My point here is that none of us could have known when to go all in.  It looks easy in hindsight.

 

In my opinion you buy when you can indentify some margin of safety and sell when things get to rich on Individual Issues.  Hedging allows you to hold individual issues through a trough without having to sell (taking gains) and without losing your upside.  Should there be losses on your puts they can be put against capital gains. 

 

Point to SD - paying down the mortgage is not a bad idea at all when you are having trouble finding values and are uninvesting in stocks.

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Taking last fall or winter for example should I have held cash until the following S&P levels:

1) 900 - wouldn't have worked

2) 800 - wouldn't have worked

3) 700 - may have worked - subject to hindsight bias

4) 600 - would have missed the entire upside

5) 500 - same thing.

My point here is that none of us could have known when to go all in.  It looks easy in hindsight.

 

In my opinion you buy when you can indentify some margin of safety and sell when things get to rich on Individual Issues.  Hedging allows you to hold individual issues through a trough without having to sell (taking gains) and without losing your upside.  Should there be losses on your puts they can be put against capital gains. 

 

 

You are absolutely right.  Trying to time the market bottom is a fool's game.  Instead, when you see value (that is, when you see securities that appear to give you an adequate risk-adjusted return), you deploy cash.  When you can't find value, cash is a good option.  Right now, it is possible to buy any number of wonderful blue-chip companies at 15-20X eps.  I tend to hold the view that most of those are fully valued at current prices.  I will not expose my capital to significant risk if I only have the expectation of a mid-single-digit return.  IMO, at 10-12X, some of those options would be a great deal more attractive.

 

Do not forget Rule #1 and Rule #2!

 

SJ

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I would prefer buying futures over options. e.g. ES-minis.

 

Why pay a premium?? It's a waste of money.

 

Or you can just by an inverse ETF or short SPY.

 

I don't understand why futures are better.  Can you explain?  I've never even looked at them so anything you give me is valuable.  Even if the market doesn't pull back and instead goes up 30%, is it still cheaper?

 

I guess I have already talked about why I like the SPY puts... something better is certainly worth knowing about.

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I would prefer buying futures over options. e.g. ES-minis.

 

Why pay a premium?? It's a waste of money.

 

Or you can just by an inverse ETF or short SPY.

 

I don't know anything about how futures work.  Would you short the minis to hedge?

 

The inverse ETFs have horrible slippage problems and don't perform anything like they should over periods of time.  They replicate the daily change only.  When you short SPY you have to pay out for distributions, so there's a premium there as well.

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I would prefer buying futures over options. e.g. ES-minis.

 

Why pay a premium?? It's a waste of money.

 

Or you can just by an inverse ETF or short SPY.

I don't know anything about how futures work.  Would you short the minis to hedge?

 

The inverse ETFs have horrible slippage problems and don't perform anything like they should over periods of time.  They replicate the daily change only.  When you short SPY you have to pay out for distributions, so there's a premium there as well.

 

 

 

The slippage problems mainly happen with leveraged ETFs.

Shorting the minis ...?? Yeah pretty much. No premium. Only thing you have to watch out for is margin.

Margin requirements on futures are usually more liberal than options.

 

 

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usually have to open a separate account.

 

most major online brokers should be able to open one i.e. IB, optionsxpress ... etc ... maybe even think or swim too.

 

with regard to hedging discussion as before ... i think there are even single stock futures on major large caps like WFC ... so you can even hedge at the individual security level.

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with regard to hedging discussion as before ... i think there are even single stock futures on major large caps like WFC ... so you can even hedge at the individual security level.

 

 

Okay, you probably thought of this one already:

1)  write the at-the-money put to collect the so called "wasted" premium

2)  hedge with short SSF

 

I'll bet there is a reason everyone doesn't just go out and do that... the problem is that you can take a loss on that SSF short position in excess of what you get from the option premium.  Now the option premium doesn't look that expensive in hindsight.

 

I think to create the same trading value from an SSF as you get with a put, you need to buy out-of-the-money calls to hedge your SSF short position from going the wrong way on you.  But that requires paying some premium for the call...  so it's not clear to me that the SPY puts are that expensive after all.

 

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I would prefer buying futures over options. e.g. ES-minis.

 

Why pay a premium?? It's a waste of money.

 

Options and futures have different economic return characteristics and saying option premiums are a waste of money is like saying insurance premiums are a waste of money.

 

Perhaps you are saying to those who want to hedge their long positions that they can do it more cheaply by using futures. However, it sounds to me like these posters want downside protection without completely giving up the upside - in this case, buying options can make sense.

 

One also needs to consider the negatives of using futures. Unless tax is a consideration, true hedges (e.g. hedging a long WFC position with a short WFC futures position) serve no purpose - you're better off just selling the long position. If you use a dirty hedge (e.g. hedging a long WFC position with short S&P futures), then you expose yourself to a double whammy (both positions could go wrong for you). You also give yourself more margin positions to look after and monitor.

 

Sure, options appear to cost more but you are getting something extra for it. Whether this is worth the cost is the real question that should be asked.

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Fair enough.

I was just comparing the downside of different hedges.

If you want to completely neutralize your position, which is what I assumed the posters on this thread wanted then you could use futures - no loss, no gain (i.e. lock in a certain level of profit) - futures will neutralize your position completely if you set the amount of contracts right in proportion to your portfolio. You can go large (with S&P futures) or small size contracts (with S&P mini contracts) to adjust it properly. If you hold cash and some stocks long, you will still be exposed to losses. You're right but, you could also just sell all your positions and hold cash. The original poster talked about an S&P hedge, and I just wanted to give him alternatives.

 

To hedge the risk in a portfolio you would take (value of portfolio / value of assets in one futures contract) = number of contracts to short. *note: in theory you would also multiply that ratio by a risk adjustment e.g. Beta or a 'hedge ratio', but let's not worry about that.

 

This would allow you to stay out of the market for a while, on the sidelines until you feel comfortable to pull off those hedges.

 

If not then you could sell and hold cash or buy an option.

However with the option chains I'm seeing, long term out of / near the money put options don't come cheap.

They're like $2.5-$5.0 per option for something like WFC.

For something like SPY at-the-money puts from Jan10 through to Dec10 cost about $2.5-$11 per contract.

 

you could also try futures-options as well. so you can get an option contract for the S&P ES-mini.

I'm not recommending a 'dirty' hedge at all, the original poster alluded to it, and I'm just throwing up ideas.

 

Me personally I would probably just sell the damn thing and hold cash. But not everyone can do that, like fund managers who have mandates, or farmers who hold inventory.

 

 

 

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