Risk – Page 130 – Slope of Hope with Tim Knight

Slope of Hope Blog Posts

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Hedging Update (by Dave Pinsen)

By Dpinsen - 15 years ago (02, Jun 2011 5:23:30 AM)

The VIX spiked 18.45% Wednesday, raising hedging costs in many cases. In the table below, I've updated the costs (as of Wednesday's close) of hedging three major index-tracking ETFs against greater-than-20% declines over the several months, using the optimal puts, along with the costs of similarly hedging a handful of their most widely-traded components, and several other ETFs.

Two new ETF additions this week

This week, I added the Financial Select Sector SPDR (XLF), and iShares MSCI Emerging Markets (EEM). First, a reminder about why I've used 20% as a decline threshold, and what "optimal puts" means in this context.

Decline thresholds

As I've mentioned before the threshold I usually use when I hedge is 20% (i.e., I want protection against any decline worse than that). The idea for a 20% threshold came from a comment fund manager (and Stanford finance Ph.D.) John Hussman made in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

Optimal puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. With Portfolio Armor (available as a web app, and an iOS app) you just enter the symbol of the stock or ETF you’re looking to hedge, the number of shares you own, and the maximum decline you’re willing to risk, (your threshold). Then the app uses an algorithm developed by a finance Ph.D. candidate to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

A note about costs

To be conservative, Portfolio Armor calculates hedging costs using the ask price of the optimal puts. In many cases, you may be able to buy the puts for a lower cost (between the bid and the ask prices).

Costs (as of Wednesday's close) of hedging against >20% declines

Symbol	Name	Cost of Protection (as % of Position value)

	Widely-Traded Stocks
INTC	Intel	3.37%***
CSCO	Cisco Systems	3.30%***
MSFT	Microsoft	3.07%***
LVLT	Level 3 Communications, Inc.	11.4%**
BAC	Bank of America	5.25%***
F	Ford	3.30%**
GE	GE	2.51%**
PFE	Pfizer	2.42%**
SIRI	Sirius XM Radio	No optimal puts: cost exceeds threshold
S	Sprint Nextel	14.9%***
	Major Index ETFs
QQQ	PowerShares QQQ Trust	1.48%**
SPY	SPDR S&P 500	1.29%**
DIA	SPDR Dow Jones Industrial Average	1.13%**
	Precious Metals ETFs
GLD	SPDR Gold Trust	0.49%**
SLV	iShares Silver Trust	8.35%***
SGOL	ETFS Physical Swiss Gold Shares	2.49%**
SIVR	ETFS Physical Silver Shares	7.27%**
	Internet ETF
HHH	Merrill Lynch Internet HOLDRs	2.56%*
	Other Sector ETFs
XLF	Financial Select Sector SPDR	2.53%**
EEM	iShares MSCI Emerging Markets	2.86%**

*Based on optimal puts expiring in November, 2011

**Based on optimal puts expiring in December, 2011

***Based on optimal puts expiring in January, 2012

Thank you

The Portfolio Armor iOS app cracked into the top-20 finance iOS apps this week:

Thanks to those of you woul downloaded it.

Follow Up on Speculative Bet (by Dave Pinsen)

By Dpinsen - 15 years ago (27, May 2011 6:06:56 AM)

In my post Thursday, I mentioned a few guidelines I've been keeping in mind when making speculative options buys (the first three of which are mentioned in Tim's book, Chart Your Way to Profits):

+ Start small (since options often expire worthless).
+ Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value).
+ Avoid nearby expiration dates (to avoid theta burn and give positions more time to work out).
+ Buy options at a discount to model estimates of their fair market value.

A Familiar Name

On Thursday night I was going through some screens, and came across a stock I'd already bought puts on a couple of weeks ago — OMER. I had bought the $7.50 strike November puts on it, but it looks like you'd be able to buy the $5 strike November puts on it for a discount to the Black-Scholes estimate of their fair market value today (Friday). More on that below, but first a recap of how I've been looking for these speculative options buys, and a reminder about the difference between speculative options buying and hedging.

Looking for Speculative Options Bets

For the bearish bets, I’ve been starting by scanning for relatively lightly-traded (average daily volume over the last month of < 250k shares), optionable stocks that look weak technically and fundamentally. The idea behind looking for relatively thinly-traded stocks is that the options traded on them are more likely to be thinly-traded, which increases the chances that they might be inefficiently priced. Then I look for in-the-money puts on them several months out, and compare the current bid-ask prices for them with the estimated fair market value of them via the Black-Scholes model.

If I find one where the most recent bid is significantly below the Black-Scholes fair market value estimate, I’ll place a small limit order for it, with the limit price set at a ~20%+ discount to the fair market value estimate.

For the bullish bets, I’ve been doing the reverse: Scanning for stocks that look strong technically and fundamentally, and looking for in-the-money calls priced below the Black-Scholes estimates of their fair market value.

Prior to today, I used this M.O. to purchase puts on JOE, NAK, MOTR, TNDM; and calls on HMC, HIT, COHR, SUP, and ASMI. I noted these purchases (and sales, in the case of HMC, HIT, and MOTR) at the time on the Short Screen message boards.

Hedging vs. Betting

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the “symbol” field of Portfolio Armor (available as a web app and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I was willing to risk in the “threshold” field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases however they will be out-of-the-money. Since I was making a directional bet with OMER, and not hedging, I bought slightly in-the-money options. This makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

OMER Again

Omeros Corporation (OMER) is a clinical-stage biopharmaceutical company. As I've mentioned before, these are the kinds of stocks I generally prefer to bet against with puts rather than by shorting them, because they can spike on news of an FDA approval, or a partnership deal with a big pharma company.

OMER has a PEG ratio of -0.4 based on analysts' estimates of its (negative, expected) earnings over the next five years.

I picked up the $7.50 strike November puts on OMER a couple of weeks ago, because OMER was trading above $5 and I wanted to get in-the-money puts (there were no strike prices between $5 and $7.50). OMER closed at $4.69 Thursday though, so the $5 strike puts are now in the money.

As of Thursday's close, the Black-Scholes estimate of the fair market value of the $5 strike, November puts on OMER was $1.73. The bid-ask on them now is $0.90 by $1.25, so even the ask is ~27% below yesterday's B-S fair market value estimate.

Another Speculative Options Bet

By Dpinsen - 15 years ago (26, May 2011 5:07:50 AM)

In previous posts, I've mentioned a few guidelines I've been keeping in mind when making speculative options buys (the first three of which are mentioned in Tim's book, Chart Your Way to Profits):

+ Start small (since options often expire worthless).
+ Avoid out-of-the-money-options (instead, try to get ones with some intrinsic value).
+ Avoid nearby expiration dates (to avoid theta burn and give positions more time to work out).
+ Buy options at a discount to model estimates of their fair market value.

I've been making bullish and bearish bets to increase the chances that some bets will make money whatever direction the market takes over the next several months. I've also been trying to take advantage of relatively low volatility when buying options.

On Tuesday night I placed limit orders for a few small bullish and bearish bets. I got a fill on one of the bearish bets Wednesday, puts on BCRX. More on that below. First, a recap of my M.O. here, and a reminder about the difference between speculative options buying and hedging.

Looking for Speculative Options Bets

Hedging vs. Betting

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases however they will be out-of-the-money. Since I’m making a directional bet in the cases below, though, and not hedging, I bought slightly in-the-money options. This makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost). If you'd like to read more about hedging, you may want to check out my latest article on it, "How not to insure a stock portfolio".

A Bearish Bet

Biocryst Pharmaceuticals, Inc. (BCRX) is a biotech company that develops small molecule drugs for the treatment of cancer, viral infections, and autoimmune diseases. As I've mentioned before, these are the kinds of stocks I generally prefer to bet against with puts rather than by shorting them, because they can spike on news of an FDA approval, or a partnership deal with a big pharma company.

Short Screen shows an Altman Z-Score of 0.86 for BCRX (recall that scores of 1.8 and lower indicate financial distress, according to the model).

I got a fill on a few of the $4 strike December puts on BCRX Wednesday.

The Trouble with Hedging

By Tim Knight - 15 years ago (25, May 2011 3:01:09 PM)

The market simply cannot make up its mind. Perhaps the powers that be simply want to bore traders to death so they don't have to worry about what will happen once the QE2 program, dreamed up by that colostomy bag of a man, Benjamin Shalom Bernanke, runs dry in a few weeks.

I have recently kept things pretty simple in my portfolio, with:

+ An absolute mountain of small short positions (dozens upon dozens);

+ One or two large long positions to balance things out

My hedging has done nothing but harm lately. Because of the whipsaw nature of the market lately, the only meaningful losses I've suffered are – ironically – from the very long positions acquired to protect me. Today was no exception.

Take a look this this chart of recent activity on the ES…….

You can imagine market participants reacting at these movements in real time:

(1) The bears are excited that the market is starting to steadily move lower;

(2) Then the bears get shoved aside, and the bulls get energized that the market is forming a beautiful basing pattern, preparing to launch higher;

(3) And then the bulls get kicked in the teeth while the bears thrill at recent lows being taken out and a wonderful late-night drop (which regular equity traders really can't exploit, since only a tiny percentage trade the ES markets);

(4) Then the bears get smacked upside the head as the entire drop is reversed and the market explodes higher, thrilling the bulls;

(5) And then the bulls have their eyes poked with a limp-wristed selloff near the day's end, giving the bears some renewed hope.

Suffice it to say, this market is pissing everyone off. I'm no exception. If putting up a sign saying "Price Pays" near your trading workstation could save you from the above, well, God bless you.

My core disposition toward the market is based upon the marvelous topping formation in the Euro, which I think will provide the badly-needed wind at the bears' backs in the coming weeks.

Of course, the distinction between the FOREX and equity markets is quickly becoming meaningless, as correlation approaches 1.0. We might as well just all become FOREX traders and not bother with anything else.

In any case, I think I'm going to give up on large hedge positions for now. If I want to reduce risk, I'll simply lighten up, which is precisely what I did today. My exposure is now only 42% of my portfolio, down from about 90%. Getting jerked around up and down gets really, really old, so I'm adopting a new tack.

That's it from me for the day. See you in the morning.

The Cost of Cowardice

By Tim Knight - 15 years ago (24, May 2011 11:01:43 AM)

I have a lot of shorts, and they tend to be heavily concentrated in the small cap and commodities space. Because of gold's and oil's strength this morning, I spent most of the day with a loss, although my portfolio has peeked its head over to profitability.

The frustrating thing was that as GDX and OIH were rising, I had a feeling they would poop out and roll over. However, my fear – – cowardice, to be more direct about it – – to short these markets denied me the opportunity to pad my profits. Conquering fear is a huge part of learning to be a consistently good trader, and with the – shall we say – challenging market of the past several quarters, I have more than my dose of caution.

In any event, the GDX was threatening to break above that green tinted area below, but I felt that was an important level of resistance. Sure enough, GDX flipped right around and started softening. The big question – – a huge question, really – – if whether it'll get soft enough to bust below that magenta area I've also tinted.

As I keep saying, the GDX is very important to watch these days. It has made a steady series of higher highs (circled in red), and as I'm typing this, it is simply closing today's gap. What the bears really need to see is a failure on the part of GDX. Should that happen, the coast is totally clear.