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Thursday, September 22, 2011

Banjo on Hedging Stock

Hedging - what's the point

A Simple Definition of Selling Short
I want to talk a minute about hedging.  But before I can do that, I need to be able for you to understand the concept of selling short.

When selling stock short, it means I borrow stock then sell it (it's all automated - I don't say "Hey, I want to borrow some stock"; instead I just sell it and the borrowing happens for me).  So, when I borrow stock (from my broker) and then sell it, I have sold stock short.  At this point, I still owe the original owner (my broker) the stock that I borrowed.  So I have to buy stock and give it to my broker.  Once I have returned stock to my broker, my short stock position no longer exists.

Sometimes people find this confusing.  They wonder, "how can I sell something I don't have"?  Well, I can't.  But if I borrow something, I can sell that borrowed item, with the understanding that I will need to return that borrowed item to the original owner at some point in the future.  Making it simple, it's the same as buying something then selling it, which you already understand by living life.  We are selling something then buying it, but it's the same, from a profit standpoint, as buying something and then selling it.

Selling Short
One thing to note - in these examples, I'm going to assume that the stock I'm long (NFLX), and the stock I'm short (SPY - actually, it's an ETF, but we're going to ignore that for this example), travel in lock step.  If I have $1,000 worth of NFLX, and it goes up $500, then the $1,000 worth of SPY will also go up $500.  This is an example only; it  may not be true in the real world, but is used to illustrate the point.  Another thing - for this example, I'm going to ignore the cost of selling short.  Those costs will be the cost of borrowing, and the cost of any dividends I may need to pay on the shares I borrowed - the real owner of the shares I borrowed are going to expect to be able to receive their dividends!

If I own $1,000 worth of Netflix (NFLX) stock, and it goes down so that I own $500 worth of NFLX, then I have lost $500 value from NFLX stock.  That should be clear.

If I sell $1,000 worth of S&P 500 (SPY) short, and it goes down so that I now owe $500 for the SPY, then I have made $500 value from   SPY stock.  If that confuses you, accept, without worrying about the 'how' that it means: I buy something, then I sell it - I'm buying it at $500, and I'm selling it at $1,000 for a profit of $500.  In reality, I borrowed $1,000 worth of SPY, which I sold for $1,000.  Then later, after the price of SPY dropped, I bought SPY back for $500, and returned those shares to the original owner I borrowed it from, keeping the $500 difference.  It should be clear that I made $500 on this transaction.  I sold it for $1,000, I paid $500 for it, so I made $500.  This is the same as - I bought it for $500, I sold it for $1,000, so I made $500.  It's the same, except the time sequence it occurred is inverted.

My definition of a hedge is something that will provide value in the opposite direction of another investment.  So, if I own stock (aka long the stock), and I want to hedge that stock, then I could sell another stock short (also known as being short the stock) if it tended to move with the stock I'm long.

Assuming I'm careful about selecting the stock I bought and it's relationship to the stock I'm using for a hedge (the stock I'm short), (in other words, they move closely together - when one investment goes down $500, the other investment will go up $500), then as the market moves up and down, the two stocks (one the long stock, the other the short stock) will move in opposite directions, with the net change being $0.

What's the point in a hedge?
What's the point in being in a hedge?   While I'm in a balanced hedge, long one stock and short another, then (assuming they move in lockstep):

  • I won't make any money on my short, nor lose any money on my long, when the market goes down.  
  • I won't make any money, nor lose any money, when the market doesn't change (doesn't go up or down) on neither my long nor my short.
  • I won't make any money on my long, nor lose any money on my short, when the market goes up.
It's as though my account is frozen; the market and my stock bounce around, up, down, and sideways, but my account balance doesn't  change much.  It may not track in lockstep, so it may vary a little, but it won't be big if I've been careful about selecting the primary investment and the hedge.

If the primary investment and the hedge are balanced, moving in lockstep then:
  • When the market goes up, my long will make money, while my short will lose the same amount; my net is $0.
  • When the market goes down, my long will lose money, while my short will make the same amount; my net is $0.
  • When the market goes sideways, my long doesn't make nor lose money, and my short doesn't make nor lose money; my net is $0.
My account balance doesn't really change.

So, what's the point?  I mean, why would I want to basically lock or freeze my account balances?

I've been asking myself this for quite a while.  I understood the concept of a hedge, but since nothing is changing, I never really could find the answer, in any of my searches, as to why would I want to my account into a situation where it doesn't change value?  Why wouldn't I just get out of the market, since when I'm out of the market my account balance doesn't change either.  So, to me, a hedge was the same as being out of the market.  And, to a certain point, that's true.  And if being fully hedged (that's one consideration - being fully hedge vs. being partially hedged) means my account balance doesn't move, then it's true that it's the same as not being in the market.

Or is it?  As it turns out, while my account balance doesn't change, some other things may change.  For instance, I could continue to collect dividends on my long positions, if they pay dividends.  And those dividends would certainly affect my account balance, in a positive manner!

So, what are some things that might change?  That might give some insight as to why I might want to employ a hedge.

Some things that might change when in a hedge

My basis
Assuming I bought $1,000 worth of NFLX stock (I'm not concerned with the price per share here in order to keep this example simple).  My basis in the NFLX stock is -$1,000 (we can ignore how many shares this is).  Suffice it to say: I am long $1,000 worth of NFLX.  I have a '-' sign in front of the $1,000 because I payed cash when I bought it, so I reflect the spending of $1,000 with the '-'.

If I hedge by selling $1,000 worth of SPY, then my basis in SPY is +$1,000.  I am short $1,000 worth of SPY.  I have a '+' sign in front of that $1,000 because I received cash when I sold it, so I reflect the receipt of $1,000 with the '+'.

If the market moves down, and NFLX and SPY move lock-step together, with (in this example) NFLX will losing -$500.  Meanwhile, the short SPY position will make +$500 profit.

Position Change (I start with $1,000 worth of NFLX, and -$1,000 worth of SPY):
NFLX: -$500  (it dropped in value by $500).
SPY: +$500 (it went up in value by $500).
net: $0 (-$500 +$500 => $0)

If I close the hedge (by buying back SPY for -$500) at this point, I receive $500 from that hedge transaction on SPY.  I sold SPY short for +$1,000, and I bought it back for -$500, so the profit is +$500.  This is the same as saying I bought it for -$500 and I sold it for +$1,000, so the profit is +$500, with the only difference being the time sequence of events - the events themselves didn't change.

So, while I lost -$500 on the NFLX, and I made +$500 on the short SPY, so the net gain or loss is $0.  No change there.  But one thing did change: my basis in NFLX changed from $1,000 to $500, from a practical standpoint..  I still own the same number of shares, but after closing the short position, they cost me only -$500, instead of the $1,000 they cost when I bought them originally.  So, while my account balance didn't change, my basis in the NFLX stock did change!

This, for me, is some additional insight I didn't have; I never thought about the fact I was changing the basis point of the long position.

So, another way to look at a hedge is to view it as a way to change a basis point in a stock.  It can work both ways, for you, and against you.  For instance, if the market had moved in the opposite direction, so that I made money in the long position, while losing money in the short (SPY), my account balance would not have changed, but my basis in the long stock (NFLX) would have gone up by $500.

So, account balance doesn't change, but stock basis changes, and it changes based upon the direction of the movement relative to the primary and hedge positions.  And, it only changes when you close the hedge.

So a full hedge can be viewed as freezing the account value, and changing the basis point until the hedge is removed.

When might I be interested in doing this?

Well, I might be interested in doing this if my goal is to hang onto stock for dividends; the account value isn't changing with the market's gyrations, but I am still receiving the dividends.  It appears this might be a way to freeze my account balance with the exception of the dividends I am going to receive.  

What else have I gained?

Well, since my account balance isn't changing, then I've removed a lot of risk, assuming the long position and the hedge position move in lock step.  Also, note that, if the stock I am using as a hedge has dividends that are payable during the time I have them borrowed, then I will pay the dividends out of my account, plus interest on the borrowed stock.  You didn't expect to get all of this for free, did you?  So maybe I should hedge with stocks that don't have dividend risk, or stocks that pay a lower dividend then the stock I am long.  That might be a good idea.

(Note that this section talks about hedging with options.  This is not something you would do unless you are an expert in trading options, and understand the obligations, risk, and pitfalls in trading options).  Another example might be where, instead of being long a stock, I am short an option.  Remember my definition above - the hedge is the opposite of the other position, the primary position I call it.  So if I decide to short a put on NFLX in order to capture time value, with a belief that NFLX is going to go up, which means I would be obligated to purchase the stock should the put expire in-the-money, then the opposite (the hedge) would be to be short calls; being short calls means I must provide the stock if the call expires in-the-money.  So, I could use the put and the call as hedges for each other.  Note a problem here though - you must understand fully the concept of deltas, gamma, and vega in order to understand the hedge, with the profit being theta.  

Some thoughts on using a hedge
I'm still looking, and thinking, about using hedges.  I know that I am only scratching the surface, but I'm having to do this on my own, as I don't have any mentors nor have I been able to find any information about the 'why' of hedging.  So, I'm sort of stumbling along on my own, trying to gain insight.  If you have additional insight, I would appreciate hearing from you!

Anything that moves in an opposite direction from my primary investment can be a hedge.  It doesn't have to be stock.  Gold is frequently used as a hedge against inflation, which is a hedge using gold against the dollar. It's important to know how tight the correlation between the primary and hedge are.  You don't want to be long some investment (long real estate, long stock, long classic cars) and think you have a hedge (long gold, short stock, short bass boats) only to find out you don't have a hedge at all; I wouldn't think long classic cars and short bass boats would be good hedge; I would think they might have a tendency move in the same direction with each other, and if that's the case, when I'm losing money on the primary, I'm also losing money on the hedge!  That's a way to lose fast!

So understanding the correlation is important.

I always assumed that should inflation kick in, I would go long rental houses or beach property as a hedge against the purchasing power of the dollar.  That certainly worked in the 1970s, but currently it's not a hedge I would put on until the housing market turns upwards.  So that hedge isn't available to me right now.  But I do have some of my portfolio on GLD, an ETF (or is it ETC?).  It's bouncing around quite a bit, and sometimes it looks like a really great hedge, and other times it looks like I've made a mistake.

Pairs Trading
One popular concept I hear bantered around is 'pairs trading'.  This is an approach, primarily using stock, where you go long the stock that is the stronger in it's sector (or where you have some belief that this is a strong stock), and go short the weaker stock.  A popular example of this is long HomeDepot, and short Lowes.  I don't have an opinion on this, I've just seen it used as an example.  

Typically, HomeDepot and Lowes have different stock prices, and may move at different rates in the market; e.g., the market is up 2%, HomeDepot is up 5% and Lowes is up 3.5%.  I use software that allows me to get a gauge on the relationship between the two stocks, so I could invest -$1,000 in HomeDepot (going long HomeDepot), while selling +$1,000 of Lowes (going short Lowes).  If they move at different rates, then it might mean that I need to go long $1,000 worth of HomeDepot stock, while going short +$750 Lowes stock.  I'm not trying to say what to do, as that will change over time, I'm just saying you need to give this consideration before doing it.  Doing a google search for stock pairs trading will give you much more detailed information then I have presented here in this little example.

So, I'm still looking for more ways to use hedging to reduce risk while providing profits.

If you know additional approaches, leave me a comment!

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