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American Capital Agency Corp. Message Board

  • engie095 engie095 Oct 2, 2012 7:26 PM Flag

    OT: Question for Angrad about hedging strategies

    Hi Angrad, I have a question about something you said in another thread (in an un-Reply-able post).

    You said:

    /// Believe it or not I have only made 2 trades where I have lost money. One when I shorted a stock, and DNDN. Everything else was either hedged or a good bet.///

    It sounds like you're saying that there were times when things didn't go your way, and your hedges saved you, but saved you so much that you made money with them. My understanding of hedging in general is that it reduces the amount you can lose, but doesn't actually allow you to make money when things go against the direction you bet. For example, instead of just selling a $33 put on BMY, I'll sell the $33 put and purchase a $32 put, to reduce my maximum loss to (strike.difference - credit received). The bought $32 put hedges my loss, but reduces my possible gain because I have to spend money to purchase it. If things go against me and the hedge is activated, I'm in the hole and will lose money on the trade.

    Do you have any examples of how to hedge to a profit on the cyclical trading of mREITs and MLPs that we discuss so often? Do the hedges you've executed reduce your chance of losing money through increasing maximum loss? I'm not sure how all that would work. Any references (books, website) for research would be appreciated.


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    • You asked for an example with MLPs or REITs. I will use my latest trade in EPD as an example.

      I bought the November 55 calls @ $0.55 and bought the Oct $52.50 puts for $0.15 between yesterday and today. 90% / 10% ratio.

      I plan on selling before Oct OPEX, but I bought the November Calls because if the stock did tank then I would be able to sell the Puts and hopefully get a pull back on the price and salvage the Calls.

    • Ok a little disclaimer here. You still have to do work. These situation do happen, but you have to find them. The most common situation is going to be Low Volatility.

      And like I said there are hundreds of different ways to hedge. Maybe I will talk about others tomorrow.

      You can find them online, but it is hard. I learned a lot of these ideas through forums and just talking to people.

      A lot of these ideas people want to be secrets. Why would you need a hedge fund if you knew how they operated, right?

    • This is going to be the last one I talk about tonight.

      This is just taking advantage of high Volatility. So you're looking at Options and the prices are just obscene. Stock is trading at $20 the $19 call is trading at $1.50 & the $21 put is trading at $1.50. (make this uniform for my sanity) You do the math and there is no way you can protect yourself in this environment and still make a profit, and if you went straight Calls you would need a 2.5% gain on the stock just to break even. What do you do?

      Well most-likely if you look down the list the price probably drops off once the Option goes OTM. So the $21 Call is trading at $0.50 and the $19 Put is trading at $0.50 (again just being uniform, it won't be like this in reality)

      So you do some quick math, and you realize that if you bought the $21 Call, and sold the $19 Call You would make $1, and if you got called on the $19 Call and the stock was trading at $20 then you would lose $1, or the amount you got for selling the Call to begin with, but wait. You could potentially lose another $1 between $20 and $21.

      Here is the beauty. If you did the same thing with the Puts, sold the $21 Put & bought the $19 Put your total gain is $1. The maximum you can lose going either way between $19 and $21 is $2, or your premium.

      So here is where it gets complex. If you know anything about options you know the more ITM you go the less premium there will be. (in Theory) Your goal to maximize profit is to capture the point where the option you bought has a good amount of premium on it, and the ITM option has little to none, and cover.

      • 2 Replies to angrad_z
      • Hi Angrad, I got distracted by the ETP storm, but I'm still working my way through your strategies. For this one:

        Wouldn't you want the option you bought to have very little premium, and the ITM option to have a lot of premium, since you're selling it? (see your last paragraph)

        Is it always balanced like in your example, where the strike prices of the calls match the strike prices of the puts?

      • HI, Angrad, I have a question for you about one of my holdings. I'm a beginner in terms of options trading. My DHI call spread 17.5/20 for Jan 2013 are somewhat deepITM. What is the best strategy for me to do for this position? Thanks.

    • Ok another way is Nonlinear Regression or just low Volatility. Target your trades when premium is so low that you can almost buy protection for free.

      So really easy example here. The price of the stock is $20 the $19 Oct Call is trading at $1.05 and the $18 Oct Put is trading at $0.05. You would do a 90% / 10% ratio

      The amazing thing about this is when Volatility is this low any significant drop in the price will double the Put and make the price of the Call stabilize, so you would end up with a situation like this: Stock goes down to $19.20 The Call would be worth $0.50 and the Put $0.35.

      Now you're adding the two up and you're saying you took a loss. Not exactly. Remember the 90% / 10% ratio. So you had $1,050 you bought $945 with of Calls and $105 worth of Puts, or 9 Calls & 21 Puts. 9 * 0.50 * 100 = $450 & 21 * $0.35 * 100 = $735 add them up and it is $1,185, or a $185 profit. (I know that would pretty much just cover commission, but when you get into bigger numbers it becomes more of a profit)

      Note: I got the numbers from a Options calculator. They are fake, but this is how the options would behave.

    • Another way is Statistical Arbitrage. This is a very complex idea, I will use it in the most simplest of forms in my example.

      So you're looking at a security, and your pricing Options out. What you are looking for is a difference in the Price greater than the difference in Strike. So you have a stock trading at $20 and the Calls are trading like this, and you will know this by watching the tape, $18 Oct 2012 Call trading at $2.02 and $19 Oct Call trading at $1.00. Now the gap in the strike is $1, but the gap in price is $1.02, so if you bought the $19 Call and sold the $18 Call you would pocket an $0.02 return on the position regardless if you get called or not.

      Then you have to take into consideration commission, so lets say it's $9.99 and $0.85/contract you make $2 a contract, so you would have to manage to sell and buy 8 contracts to break even. As soon as you start doing this the Specialist is going to notice and almost immediately adjust the price.

      Most common way people manage to do this is to get your Broker in on it. It is going to cost you more in commission, but the Broker has no problem screwing over a specialist. Figure out how many contracts you'd need for a phone assisted trade. Tell your broker it's an all or none trade on the spread. What they can do is in a millisecond send both orders into the system and fill them both at the same time.

    • There are hundreds of ways to hedge. I can talk about some, but for my to really go into detail about a lot of them would take hours of typing.

      One way is called 100/30. In this hedge what you would do is find a stock with a low Beta and it out performing the sector and go long in it, then you would find another stock and short it in a 100% long 30% short ratio. Take the money from the short and put it in your long position. This works because if you did it right and the sector dropped then the stock with the higher Beta would drop faster. For example if we had a stock that out performed the sector by 10% with a Beta of 0.50 and another that under performed by 20% with a beta of 2 and the sector dropped 20%. In Theory the stock that out performed would only drop 10%, while the stock that under performed would drop 40%.

      Now the Math: In this example both stocks trade at $10. You invest $1,000 in stock A and you short stock B for $300 and add it to stock A. So your position looks like this Stock A $1,300 Stock B (300). Sector drops 20%. Stock A loses 10% and your position is worth $1,270 Stock B falls 40% and your position is ($120). $1,270 + ($120) = $1,150 you made $150.

      I will post other strategies later including Option strategies.

      • 4 Replies to angrad_z
      • This looks similar (though more complicated) to something Jaded Consumer posted a while ago about buying Apple and shorting RIMM as a hedge in case the whole sector dropped, but I don't recall him discussing betas.

        I put some numbers into a spreadsheet and I see what you're getting at. You're mosty neutralizing the movement of the sector (I assume you're using a sector beta, not a whole-market beta?) so that you can just play Stock A against Stock B.

        Just a note about your example, by my calculations Stock A losing 10% would be $1170, and Stock be would be at -180, giving a net of $990 instead of $1150.

        It looks like if you wanted a perfectly neutral strategy, you could take the ratio of the betas (say the 2/0.5 or 4:1 ratio) and use a strategy with the same ratio. For example, a 100/25 strategy. Interesting stuff.

        I haven't gotten into playing one stock against another, but I see the value in this strategy.

        Thanks Angrad. Now you've got me reading about hedge funds. heh

      • Wow, Angrad, thank you for posting such good stuff. I want to spend some time understanding each of the strategies you've laid out, but before I get there I just wanted to let you know I appreciate such effort in explaining all this to us!

      • Math is wrong on this, sorry. I am writing this from my phone and rushing through it. it would be $1,170. Profit of $50.

      • Sorry, Low Beta in the long High Beta in the short. The short in Under Performing.

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