How would you hedge this portfolio?

[Compounder]

The more I read and look at the economic environment the more I feel like I should consider putting in place some hedges for my portfolio. Not because I'm concerned that the businesses I own are overvalued - I believe they are undervalued and come with a large margin of safety - but because I would like to reduce market risk, and reduce volatility in my yoy track record. The portfolio presently is comprised of:

 

LONG -

American Insurance Group (Common & Warrants)

Bank of America (Common & Warrants)

Chesapeake (Common & Leaps)

CF Industries (Common)

Gale Force Petroleum (Common)

Blyth Inc (Common)

 

SHORT -

20+ Year Treasuries (ETF)

Bank of America (Jan 15 $12 puts)

 

I'm interested in the board's thoughts on how you would hedge against some of the market risk in such a portfolio?

 

Thanks!

 

[dutchman]

If you have cash, be prepared to buy more of your first three longs at cheaper prices ! I think that would be your best hedge, but I'm biased!

[Compounder]

If you have cash, be prepared to buy more of your first three longs at cheaper prices ! I think that would be your best hedge, but I'm biased!

 

Yes, should have mentioned the reasonable ~20% cash position, and that buying more of the existing positions should they decline is the plan.

[constructive]

I'd get rid of the BAC warrants. BAC warrant holders on COBAF seem to be trending towards common or ITM LEAPs instead. Warrants don't really support the goal of reducing volatility.

[GregS]

If you are concerned about a correction, perhaps cover the treasuries short?  If the market drops and/or there is panic in emerging markets, flight to safety would likely benefit treasuries.

 

Other than that, I like cash and opportunistic buying as a hedge.

[Lance]

If there's another sell-off Monday morning you might consider selling puts on AIG, BAC and CHK. 

 

Thanks,

Lance     

[Compounder]

If there's another sell-off Monday morning you might consider selling puts on AIG, BAC and CHK. 

 

Wouldn't this act as the opposite of a hedge if the markets corrected further? If markets were down quite a bit and VIX spiked significantly I like the idea of selling these puts, but not sure about it at the moment?

[Vish_ram]

A textbook approach to hedge is to compute the beta of your portfolio and then use S&P futures (short) to hedge it.

[Lance]

If there's another sell-off Monday morning you might consider selling puts on AIG, BAC and CHK. 

 

Wouldn't this act as the opposite of a hedge if the markets corrected further? If markets were down quite a bit and VIX spiked significantly I like the idea of selling these puts, but not sure about it at the moment?

 

Compounder, it's not really a hedge, more an extension of GregS' comment regarding opportunistic buying - ie if there's a sell-off and these three plunge the premiums should increase and you can purchase more shares while collecting the premium from selling puts.  If the stocks don't ultimately decline below the strike price you sell at you keep the premium.  I would not use your entire 20 percent cash allocation Monday, just some small portion of it.  If you feel the markets are going to decline for some time, wait for better prices.

 

I sell puts gradually during sell-offs with strike prices just below the current price, but only if it's a price I wouldn't mind owning the stock at.  I then sell calls on the way up.  Not entire positions, just around the edges.

[Compounder]

Thanks Lance. I like the overall strategy.

[twacowfca]

A textbook approach to hedge is to compute the beta of your portfolio and then use S&P futures (short) to hedge it.

 

That's a good way, but I would suggest a modification that makes sense.  Consider the qualitative difference between beta which assumes a normal distribution and the concept of up or down volatility.  Ziemba has used this insight to develop a modified Sharpe ratio that doesn't penalize a stock or fund manager for up volatility over time but only for down volatility. 

 

Thus, a stock might be observed to have stronger up movements with the market than down movements.  The calculated beta for that stock might be low, but should be even lower when the market goes south. Other stocks might be especially succeptable to down vol with even deeper plunges when the market turns down than a mere calculation of beta would predict.

 

A small number of stocks might be observed to have a fairly high positive correlation with market movements that are up, like those that comprise most of our portfolio. These might closely follow or only slightly lag the market when the market is up, but have great resistance to following the market on the way down.

 

 

[frommi]

If you want to reduce volatility i would at first get rid of leverage, so sell warrants & leaps. Selling puts does the opposite you are more leveraged and can blow out when the market spikes further down and you don`t have enough cash to buy the stocks at that prices. I don`t think its a bad idea but it doesn`t fit your goal of reducing vol. But since you wrote that you have 20% cash on hand i would probably do nothing, just ride it out and use the cash on the way down. Just live with the vol.

[ItsAValueTrap]

Sometimes the best hedge is no hedge.  The problem with hedges is that most hedges won't work all of the time.  So you will run into a situation where you are losing money on your portfolio and losing money on your hedges.

 

However, put options are a good hedge.  If the stock goes down, the put option will almost certainly go up.  (Unless implied volatility on the put option drops, but the chances of that happening are low.  And you don't need to care about that if you can hold the puts to expiry.)

 

Implied volatility on Chesapeake is pretty low right now.  I think that the options are attractive.  I happen to be shorting CHK via puts.

 

2- Is the borrow on Blyth expensive?  You might be able to get some free money by lending out your shares.  If your broker won't let you do it, you can make a synthetic long position via options.  This will let you capture the borrow though you have to put transaction costs.  Or... just buy the call options and sell the common.

[Compounder]

Thanks all for your contributions so far.

 

Those of you that do use beta as an input in hedging out some of the volatility, where do you get your stock betas? do you calculate it yourself or source it from somewhere else?

[twacowfca]

Thanks all for your contributions so far.

 

Those of you that do use beta as an input in hedging out some of the volatility, where do you get your stock betas? do you calculate it yourself or source it from somewhere else?

 

The problem with reliance on sites that calculate beta or vol is that they seem to be based on the idea that the observations of short term volatility and covariance will be scale invariant over time and follow a normal distribution.  If one is a fund manager concerned about career risk who doesn't want to look worse than his peers, this makes sense.  However, if one wants to do much better than 99% of market participants, downplay beta and see what each stock does over time when the market makes big moves, and then ask: is there reason to think that things will be different this time for this stock?