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What are the best hedges for a "calamity"?

 

There are the inverse ETF's of course.  They do worry me re: the constant leverage problem, i.e. the daily rebalancing can lead to horrid returns with volatility.

 

And of course there are those who say it is time to take off the hedges, like Sir Watsa,  as the majority of the downturn (markets that is) maybe over.

 

We are slightly hedged, (I wish we had been more, but those are the breaks), but I expect that there is  going to get a bounce up from here, so I want to be prepared to put in a better hedge in preparation for another leg down.  So I am looking for any ideas out there. (By the way, I think BAC and C are potentially zero's but I don't like the risk reward.

 

 

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Guest ericopoly

My strategy changed a bit now that FFH has taken off the hedges.

 

This week I wrote 2010 puts on:

MSFT at $12.50  ($1.37 premium)

GE at $5 (98 cents premium)

AXP at $5 ($1.75 premium)

SHLD at $12.50 ($2.50 premium)

WFC at $10 ($3.50 premium)

 

I took the option premium and bought 2011 FFH at-the-money $250 calls.

 

The transaction leaves me with the downside of the deep-out-of-the-money puts, but the upside of FFH at-the-money

 

I did not take on any leverage on the downside (I have the cash to buy the shares, or take delivery on my calls  -- whichever of those two outcomes it may be).  Worst case is, I get assigned and own the companies at those prices -- but I still have upside from the FFH calls.  I could then hang onto both and get double upside.

 

But I think more likely is that I won't get assigned on all of them, maybe some of them but likely not all.

 

Now, the puts I wrote expire in 2010, but the FFH leaps don't expire until 2011.

 

So, in January 2010, if the puts expire worthless I can then use my cash to buy FFH shares -- while still holding onto the calls.  So then I'd have 2-for-1 leverage in FFH.  Or I can repeat the exercise if volatility premiums on puts are still attractive vs FFH calls.

 

 

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Ericopoly,

 

Sounds like an interesting strategy.  Its kinda like you hold a convertible debt position in your FFH position where the yield on the debt is the premium on the puts you sold.  And the whole debt position would convert to those underlying stock positions in a huge bear market - which you would likely want to do anyway.

 

Makes a lot of sense to me as long as you like those 5 names at those prices.

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Guest ericopoly

as long as you like those 5 names at those prices.

 

 

Oh, and one other thing.  Suppose MSFT is at $10 when I get assigned -- these things, when they get that ridiculously crazy, have insane volatility premiums.  Like SHLD back in November -- the $25 strike 2010 put was going for $11!  That's fricking nuts.  WFC $15 puts are going for $5 right now, LUK $15 puts are going for $4.6 yesterday, or day before.

 

So...  in 2010, if I get assigned but don't really want them more than FFH... I can then write calls all year long at the original strike price to gain more premium (dig down the cost basis).

 

But, at $11.50, SHLD would be trading at it's current cash level.  At $5 AXP would be 1/2 of book value, at $12.50 MSFT would be at like a P/E of 5, at $5 GE would have a dividend yield of 25%.  Anyways, I could go on and on but you get the point.

 

Plus, FFH has that natural hedge built into it (the operating income digging them out of mark-to-market equity losses).

 

Now, if we have another pump-fake bear market rally during this year I may be able to buy these puts back really cheap.

 

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I think that approach makes a lot of sense, but isn't quite hedging for "calamity" as the OP wrote.    I would think that if by some chance you were assigned all those shares, that your FFH calls could end up finishing OTM as well, just because it would reflect a decimation of the equity market.   

 

Throw a few OTM S&P puts into the mix, and I think you're well insured, without having to pay too much.    I figure if you end up owning all those shares, S&P 500 would likely be coming into play, and you can still protect against that fairly cheaply.  If you get real lucky, the strong survive while the rest of the market dives, and all those bets pay off ;D

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Guest ericopoly

"I would think that if by some chance you were assigned all those shares, that your FFH calls could end up finishing OTM as well, just because it would reflect a decimation of the equity market.  "

 

I totally agree, which is why I'm buying at-the-money LEAPS on FFH.  I have no FFH downside at all!  The premium paid for the calls was earned by writing the puts.

 

That's what is so damned funny.  When FFH was at $250 it cost me $50 for the 2011 $250 leaps.  That's a premium paid valued at 20% of the strike price.

 

I mean, with 1.6x equity leverage in bonds, and 0.8x leverage in common stocks, and 0.2x leverage in preferrreds, that amounts to 2.6x leverage for some superior upside!  And with catastrophy risks as well!  Yet... can you figure this one out... the premium for at-the-money KO LEAPS is exactly the same!  I mean, what the heck is up with that? 

 

Mr Market says Coke is just as risky as FFH!

 

 

 

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Guest ericopoly

ericpoly,

 

Have you tried any straddles in options? Any arbitrage opportunities?

 

 

I don't like the straddle because my FFH downside is already protected by the call.  I'm expecting FFH to go up, I am optimist by nature.  I can't stand shaving 20% of my investment capital, which is what would happen if I bought a bunch of puts that decayed to zero.

 

I don't have a job so while some of you might enjoy seeing FFH trade at 1/2 of book (like WTM), I would not.  In that scenario, I would be very upset and crazy.  So I'd rather do things my way and "risk" buying things at completely nutty prices.

 

And I can't just hold cash because I'm greedy.  I can't sleep at night thinking that I'll miss out on FFH at $250, trading at 6x operating income (3x or 4x including capital gains).

 

So, I need to always feel like I won't miss a rally, and always feel like I won't miss a buying event of our lifetimes, and yet I'm too cheap to spend 20% of my capital buying puts.  So my solution thus far is the only one that meets all of my goals.

 

 

Arbitrage is too hard for me.  FFH is easy because those guys can make all the hard choices (they give me a diversified deep value leveraged portfolio by proxy).

 

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FFH is a PandC insurance company, albeit an excellent one, so you have to be prepared for some volatility. What if we have a major earthquake in California this year? Or a wave of municipal defaults shave off the market prices of their portfolio?

 

Or what if the real estate bubble lasted until 2010 and a chunk of the CDS gains never occurred? You would still have the great team in place, but without the one time gains, FFH's market cap would have cratered. If you need consistent results, an insurance company might be too volatile.

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Guest ericopoly

FFH is a PandC insurance company, albeit an excellent one, so you have to be prepared for some volatility. What if we have a major earthquake in California this year? Or a wave of municipal defaults shave off the market prices of their portfolio?

 

Or what if the real estate bubble lasted until 2010 and a chunk of the CDS gains never occurred? You would still have the great team in place, but without the one time gains, FFH's market cap would have cratered. If you need consistent results, an insurance company might be too volatile.

 

 

 

Why would I care?  Calls give me the option to buy at $250 in 2011, not the obligation.

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Guest ericopoly

For the record, I do actually have some $280 strike 2011 calls and some $200s and some 2010 $120 and $130.

 

So I would care somewhat if FFH goes down.  But... I don't need to discuss that for the sake of this hedging strategy. 

 

I hedged only what I cannot afford to lose.

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