A Trader’s Guide to Hedging Strategies – Part 1

By Michael Davey

Enough light fare for this series – it’s time to get into something a little more complex.

Okay, not too complex. I’m just one guy with one approach and I don’t have a super-computer on the payroll here. All the same, I’m going to attempt this – but it will have to come in several pieces.

This first installment is mainly an overview, which means it will not yet be saving any lives

Overview: Let’s break the objective of trading and investing into two basic categories – capital appreciation (a universally shared obsession, certainly with this crowd) and capital preservation (a problem we all wish we had more of, but a real problem none the less).

1). Capital Appreciation: Placing capital at risk in order to generate a capital gain. The most relevant issue then is our degree of risk relative to our potential gain. Flipping a coin with 3-2 odds is a bet you want all day long, while collecting sea shells ahead of a tsunami is best avoided.

In order to measure our risk vs. reward, we need to identify both potentials and, especially on the risk side of the fence, we need to identify our target for bailing-out (taking losses). This sounds incredibly basic, and it is, but we’re reading these lines anyway since it is so easy to get off-track of this fundamental principle of speculation (make damn-sure your stand to gain more than you’re risking). If you don’t know where to cut losses, or you change your mind for whatever reason once they begin to develop, you’re allowing losses to run and you’ve undermined an otherwise reasonable discipline (or perhaps you have no plan at all, in which case you need to take a couple prerequisite courses before sitting in my class – on your bike in that case…off you go!).

2). Capital Preservation: Protecting what we already have.

Let me run on about this (first, because this chapter regards preservation and secondly because my pen has a tendency to run on a bit).

The more we have already, the more preservation trumps appreciation. This too is obvious, but needs to be addressed. Pissing contests aside, if I as an individual have $10B in worth, my number one objective is preserving that wealth. Otherwise, what kind of fool am I? Sure, I can afford to play (and I would , but at the end of each day I’m driven by thoughts of insurance more than by greed – defence rules my game. A great deal of my time is focused on current affairs, potential uprisings, wars and other forces majeure; looming bond, currency and/or equity crisis’ and how I’m going to respond; as well as diet, exercise and wooden teeth (general self-preservation). In short – I’m at the top and I’m rooting myself and my fortune accordingly. Yep, life gets a little boring in this state, but we all have our struggles, right?

On the other extreme, if I have $500 of investment capital then I’m looking to gamble. I’m not wasting time trading markets in this case – I’ll be grinding teeth at the .10/.25 tables in order to build something worthy of investing.

On your bike??

Okay, fair to say then that the rest of us fall somewhere in the middle. Very good. And while it’s impossible to reduce this to a simple formula, since we each have varying complex individual circumstances, which vary in and of themselves, we can agree (methinks) conceptually with the idea that our need to protect increases or decreases with a portfolio’s net-worth (as well, of course, with our perceived opportunity vs. risk in the current marketplace and metrics of that regard).

That’s really simple stuff, but I mention it because I’ve been shocked too many times at how little some vary strategy when their investment stake increases dramatically. For myself, if I’m living a modest existence, working like mad just just to tread water and my $5,000 portfolio of 1 stock explodes to $50,000, well I must be the biggest gambler in the world, no? If it increases then to $100,000 and I’ve not sold a single share, I’m basically a chump who’s had incredibly good luck. If you don’t know people like this, I can tell you they are out there.

A partner of mine in the mid-90’s had a family member who invested 5k into a Canadian penny-stock (Bre-x Minerals), the company who held the rights of a major new gold strike in Borneo. His 5k ran to over 100k, as the stock traded north of $20/share. Turns out this was not just a major strike, but based on early testing samples this was the biggest mother-load ever discovered. So big in fact, the little company had to shop itself to the world’s largest miners in order to joint-venture mining such a heap (there would be too much for them to handle alone). For the life of me I don’t know why you wouldn’t take something off the table in this situation – what are you expecting, $100/share? Then, when the chief geologist fell to his death from a helicopter into the jungle (the validity of which is still questioned about today) and the stock crashed to 15 or so on major volume, for the life of me I don’t have a good reason why you shouldn’t take something off the table. When the stock drove drove drove then all the way back under $1, ahead of Freeport coming in to test new samples, I cannot imagine not taking something off the table. Stocks really do talk sometimes, if you know how to listen.

Bre-x ultimately opened at about 12 cents/share the Monday following the test results and ended up g00se eggs in relatively short order.

Total loss? – you tell me, $5,000?

Yet it’s not only this way with penny stocks. I know of people who have been made wealthy by Apple Computer, buying 5 and 10 years ago and never-yet selling a share. It’s one thing if you’re Bill O’neil, you’re wealthy and you catch Cisco in the early 90’s and ride it several thousand percent. But it’s completely, utterly stupid if your entire portfolio was built big on one stock and remains 99% of a multi-$million stake. Apple is not going to be found out to be nothing but a scam, but a round-trip to below $20 in your lifetime is far from out of the question.

Ride your winners, absolutely, but at some point pigs will get slaughtered. Don’t forget about that one.

Types of insurance:

1). Options (covered calls, put-options, etc): I don’t use options for hedging and I am far from expert, so I’m going to avoid this one (when the book comes out I’ll have someone else guest-write this strategy).

2). Shorting stocks against other longs: If done wisely (requires being short weaker names than one is long), this strategy can both protect longs and generate gains – sometimes even in an up-market. Note: the opposite is equally appropriate – buying stronger longs against a position short, etc.

3.) Shorting indices (Futures, ETF’s, buying inverse-ETF’s, etc.): A (sometimes) simple way to protect large-cap longs and a bit trickier method for protecting mid or small-cap longs. Example: if I am committed to holding AAPL long and become bearish on the market, I can simply short an effective-dollar amount of the NDX and I’ve theoretically neutralized my risk. This can be done by shorting equal-dollars of ETF QQQQ, by going long 50% the dollar-amount of inverse-ETF QID, or by shorting 10% of the dollar-amount of an NDX futures contract). Note: 2x’s and especially 3x’s ETF’s have a bleed-factor when in decline which must be addressed. There are also annual Q4-distributions possible (certainly when those funds have a sizable cap-gain going into that time of year), which we’ll also cover.

4.) Moving to the sidelines: An under utilized strategy of simply getting out of the way in a tricky environment. You give up potential gains, but you protect capital while awaiting a better set-up for speculation. Reducing exposure also qualifies and is highly recommended by this trader, whenever an account is bleeding capital. I like to scale in and out, as far as total exposure, according to the direction of gains/losses.

This way I maximize gains and minimize losses.

That’s pretty much it for Part 1. I want to cover these points in detail and spend some time with my own strategy of hedging (which varies according to my perception of the market outlook, momentum, volatility, etc.).

I hate to promise this, since I’ve not drafted any more than this overview so far, but I’ll go ahead and risk that a bit of failure. If I’m only walking out, into the receding tide, gawking amazed at the newly exposed sea floor – well then I’m going to end up sucking water in rather short order.

Sea shells firmly in hand.

Homework: If you don’t understand something above then fire questions at me so I might cover it going forward. If you disagree with something, then fire even harder

Previously in this series:
A Trader’s Guide to Contractions
A Trader’s Guide to Sipping Kool Aid
Losing Like a Winner: A Trader’s Guide
A Trader’s Guide to Secondary Offerings (Part 2)
A Trader’s Guide to Secondary Offerings (Part 1)
A Trader’s Guide (Introduction)
A Trader’s Guide to Chasing Ambulances
A Trader’s Guide to Exhaustion

This entry was posted on Thursday, December 10th, 2009 at 5:17 pm and is filed under Trend Trading. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.