Slope of Hope Blog Posts

Slope initially began as a blog, so this is where most of the website’s content resides. Here we have tens of thousands of posts dating back over a decade. These are listed in reverse chronological order. Click on any category icon below to see posts tagged with that particular subject, or click on a word in the category cloud on the right side of the screen for more specific choices.

Hedging Update (by Dave Pinsen)

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In the table below, I've updated the costs (as of Monday'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 precious metals ETFs.

Two new ETF additions this week

In the wake of LinkedIn's IPO last week, I also added two Internet ETFs (I suspect when those two ETFs update their top holdings, LinkedIn will be one of them). 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.

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

Symbol

Name

Cost of Protection (as % of Position value)

Widely-Traded Stocks

INTC

Intel

1.84%*

CSCO

Cisco Systems

2.02%*

MSFT

Microsoft

1.49%*

LVLT

Level 3 Communications, Inc.

17.5%***

BAC

Bank of America

3.50%**

F

Ford

4.53%***

GE

GE

3.82%***

PFE

Pfizer

2.19%***

SIRI

Sirius XM Radio

10.0%***

S

Sprint Nextel

7.00%**

Major Index ETFs

QQQ

PowerShares QQQ Trust

1.95%***

SPY

SPDR S&P 500

1.63%***

DIA

SPDR Dow Jones Industrial Average

1.39%***

Precious Metals ETFs

GLD

SPDR Gold Trust

0.66%***

SLV

iShares Silver Trust

4.52%*

DBP

PowerShares DB Precious Metals

1.71%*

SGOL

ETFS Physical Swiss Gold Shares

3.25%***

SIVR

ETFS Physical Silver Shares

7.59%***
Internet ETFs
FDN First Trust Dow Jones internet 10.0%*
HHH Merrill Lynch Internet HOLDRs 2.91%**

*Based on optimal puts expiring in October, 2011

**Based on optimal puts expiring in November, 2011

***Based on optimal puts expiring in December, 2011

Twitter

I've noticed other posters here mention that they are on Twitter. In the event anyone's interested in my occasional tweets, here's my Twitter ID (or handle, or whatever it's called): @dpinsen

A Missed Opportunity (by Dave Pinsen)

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In a post here last week (Revisiting a Losing Market-Neutral Trade), I mentioned a market neutral trade where I got stopped out of the short side for a loss. I got stopped out of the short side of a more recent market neutral trade (Short TRGL, Long IMO) for a gain, but I missed an opportunity in not buying puts on TRGL after getting stopped out.

TRGL versus IMO

The chart below shows the performance of TRGL and IMO from when I entered the trade on 3/31/2011 until when I exited on 4/21/2011. I started out with 24% trailing stops on both sides of this trade, but as I noted on Short Screen at the time, I tightened those trailing stops on both sides (to 8%) on 4/19. So I got stopped out of TRGL early on 4/21 — at $7.58, instead of $8.85, which is where it closed that day. Once I got stopped out of TRGL, I sold my long position in IMO. Overall, it wasn't a bad trade: I made 3% on the long side and 30% on the short side, for a combined return of 16.5% on the combined trade.

IMO, TRGL

Why TRGL popped on 4/21

The company, an oil & gas E&P with its operations in the Paris Basin, had been under a cloud as the French government considered banning shale exploration for environmental reasons. On 4/21, the company commented on an interim report about shale exploration by a French government agency, but there was nothing conclusive about that report; the pop on 4/21 looks like it was a simply a short squeeze.

Performance of TRGL from 4/21 until this week

The chart below shows how TRGL shares have done since I got stopped out on 4/21.

  TRGL

Why this was a missed opportunity

Because the bearish case against TRGL hadn't materially changed on 4/21, so I should have taken advantage of the bounce and bought in-the-money puts on it then. I didn't think of that at the time.

Buying puts on a stock after getting stopped out of a short position

The odd thing is that I did do that when I got stopped out of the short side of another market neutral trade (Short JOE, Long GTY) for a loss earlier this year. Since I thought the bearish case against JOE remained intact, I bought long-dated, in-the-money puts on it (which I'm still holding). It's something I'll consider going forward when I get stopped out for gains as well.

A reminder about hedging versus betting

Those puts on JOE were a speculative bet against  the stock; because of that, I bought in the money puts on it, consistent with Tim's guidelines about buying options in Chart Your Way to Profits. That 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 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.

My most recent market neutral trade

I entered another market neutral trade last Friday, long ALB, short ADES. More details on that at the link.

Another Two Speculative Options Bets

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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 (though if volatility keeps ticking up, I may start to hold off on making new speculative options buys).

On Tuesday night I placed limit orders for several small bullish and bearish bets. I got a fill on a two of them during the day Wednesday, calls on IXYS and puts on OMER. More on those below. First, a recap of my modus operandi here, 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 < 200k-225k 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 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’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).

A Bullish Bet

IXYS Corporation (IXYS) is a an integrated semiconductor company. 

IXYS has a PEG Ratio of 0.29, based on analysts' estimates of its earnings over the next five years.

IXYS Chart

As of Tuesday's close, the Black-Scholes estimate of the fair market value of IXYS's $15 strike, October calls was $2.23. I bought them for $1.80 Wednesday (the B-S estimate of their fair market value dropped to $1.97 after Wednesday's drop in price of the underlying).

A Bearish Bet

Omeros Corporation (OMER) is a clinical-stage biopharmaceutical company. 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.

OMER Chart

As  of Tuesday's close, the Black-Scholes estimate of the fair market value of the $7.50 strike, November puts on OMER was $3.50. I bought them at $2.85 Wednesday (the B-S estimate of their fair market value rose slightly to $3.57 after the drop in the underllying Wednesday). 

Revisiting a Losing Market-Neutral Trade

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In a post here in December ("Market Neutral Investing in China's Fast Food Industry"), I mentioned a market neutral trade I had entered going long Yum! Brands, Inc. (YUM), the largest fast food operator in China, and shorting Country Style Cooking Restaurant Chain, Ltd. (CCSC), a start-up fast food chain in China. I figured the bigger potential there was on the short side.

Reasons I shorted CCSC as part of this trade

  • + Its chart looked weak, with the stock trending down since its IPO last fall
  • + Its valuation looked pricey relative to its earnings, even after adjusting for growth estimates.
  • + Anticipated selling pressure when the 6 month IPO lockup period expired for insiders.

Getting Stopped out for a Loss

I used double digit trailing stops on this trade, and got stopped out of CCSC at $25.38, for a loss of 11.3% on the short side on Jan 4, so I sold out of YUM as well, at $48.21, for a loss of 4.8% on the long side. Total loss of 8% on this market neutral trade. Below is a chart of both stocks from when I entered the trade, on December 2nd, 2010, until when I exited, on January 4th, 2011. 

 

 

Hindsight is 20/20

Had I used wider stops, I might have stayed in the trade long enough to profit from it. Below is a chart of both stocks from when I entered the trade, on December 2nd, 2010, until Monday, May 9th, 2011. Note the selloff at the beginning of March: the company released earnings on March 2nd, missing analysts' estimates.

 

This wouldn't have applied in the case of CCSC, since it doesn't have options traded on it, but a suggestion that has come up recently from a couple of Portfolio Armor users is extending its algorithm to find optimal calls for hedging short positions.

Recall that 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 to get you the level of protection you want at the lowest cost.

Adding the ability to hedge short positions with optimal calls is something I'm considering adding, if enough users request it. If we do add that functionality, we'll probably raise the price, to offset the development cost, but those who subscribed to the web app beforehand would be grandfathered in at the current cost. I don't know if we'd add the functionality to the iOS app too, but there again, if we do, current users would get the upgrade without paying more.

Hedging Update (by Dave Pinsen)

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In the table below, I've updated the costs (as of Wednesday's close) of hedging the Dow-, NASDAQ 100-, and S&P 500-tracking ETFs against greater-than-20% declines over the next several months, using the optimal puts, along with the costs of similarly hedging a handful of their most widely-traded components. As with the last hedging update post, I included five precious metals ETFs to the table as well. First, though, a quick update on a couple of speculative options bets, and a reminder of why I'm using ITM puts for directional bets and optimal puts for hedging purposes.

Two more speculative options bets

On Wednesday, I got a fill on ITM October calls on Superior Industries (SUP) and ITM December calls on ASM International, NV (ASMI) (I had entered limit orders for several bullish and bearish bets, but those two calls are the ones that I got filled on). Same M.O. with these as I described with COHR earlier this week: using the guidelines Tim mentioned in his book Chart Your Way To Profits, plus the additional guideline of buying options at a ~20%+ discount to model estimates of their fair market value. I mentioned both options buys on Short Screen during the day Wednesday.

Hedging versus betting

To find the optimal puts for hedging, I enter the symbol of the stock or ETF I'm looking to hedge in the “symbol” field of Portfolio Armor (available on the web and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I'm willing to risk in the “threshold” field. Then Portfolio Armor uses its algorithm to scan for the optimal puts to provide 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 directional bets in the cases above, though, and not hedging, I bought slightly in-the-money options. That 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).

Chosing a threshold

When using Portfolio Armor, you can enter any percentage you want in the threshold field (though the larger the percentage you enter, the more likely there will be optimal puts available for that level of protection). 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

Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So 20% is the threshold I've used in the table below.

Times to expiration

In his research, the finance academic who developed Portfolio Armor's algorithm found that options with approximately six months to expiration (which today would be the ones expiring in November) tend to offer the best combination of liquidity and cost, so those are the put options for which Portfolio Armor's algorithm aims. When puts with about six months to expiration are not available, Portfolio Armor searches for slightly longer or shorter times to expiration.

A difference in the table this time

Note that, unlike in the table last time, when the hedging costs of the index ETFs QQQ, SPY, and DIA were based on optimal puts expiring in October, this time they are based on optimal puts expiring in December (December 29th, to be exact, in the case of DIA and QQQ, so that's almost 8 months of insurance from today). All things equal, options with expirations further out generally cost more.

 

Symbol

Name

Cost of Protection (as % of Position value)

Widely-Traded Stocks

INTC

Intel

1.62%*

CSCO

Cisco Systems

1.60%*

MSFT

Microsoft

1.42%*

ORCL

Oracle

3.18%***

BAC

Bank of America

2.40%**

F

Ford

4.16%***

GE

GE

3.16%***

PFE

Pfizer

2.23%***

WFC

Wells Fargo

3.23%*

T

AT&T

1.35%*

AA

Alcoa

2.40%*

Major Index ETFs

QQQ

PowerShares QQQ Trust

1.77%***

SPY

SPDR S&P 500

1.56%***

DIA

SPDR Dow Jones Industrial Average

1.41%***

Precious Metals ETFs

GLD

SPDR Gold Trust

0.85%***

SLV

iShares Silver Trust

4.60%*

DBP

PowerShares DB Precious Metals

1.66%*

SGOL

ETFS Physical Swiss Gold Shares

2.99%***

SIVR

ETFS Physical Silver Shares

2.56%***

*Based on optimal puts expiring in October, 2011

**Based on optimal puts expiring in November, 2011

***Based on optimal puts expiring in December, 2011

Disclosure: I'm holding some puts on DIA, and some calls on SUP, ASMI, and COHR.