Employing Hedging Strategies to Lower Risk

Includes: CMG, CRM, LULU, OPEN
by: Hedgephone

With so much in the press lately about "bears being wrong" and "missing the rally", I wanted to discuss a strategy that is neither inherently bearish nor bullish but earns a consistent return over time-- long and short investing using options for leverage and income.

A.W. Jones was arguably the first traditional hedge fund, but a few of the unsung heroes of the Depression era investing were investors using a risk averse hedging technique. Some of these long and short investors were Ben Graham and Roy Neuberger (My condolences on his recent passing). Neuberger shorted enough RCA stock to breakeven during the great crash, while Graham had used hedging techniques to boost returns with leverage prior to the great crash, although following the crash he used almost exclusively his cigar butt long only basket technique.

It was A.W. Jones who ran the first long term focused long short equity fund with a typical 70% net long bias with $1.10 of longs and $.40 of short positions. In this formation, investors take advantage of bull markets as their short positions in theory rise less than the market and their longs can outperform the market while guarding against market crashes and preserving capital.

Investors today can sieze opportunities on the long and short side through the use of covered call writing, put option buying and spread trading. In a sense, the use of equity derivatives on the short side can prevent large losses from the infinite loss potential that is inherent in selling a stock short -- nothing is worse than holding a three bagger short.

Buying an option spread where the long put is two strikes in the money and selling an at the money put can conserve capital in sharply rising markets such as the market we just encountered. In my mind, the use of leverage carries added speculative risk, as does the risk of a short position doubling or tripling against you in a short period of time. Diversification on the short side is notably the most important rule for me after trying to find the best hedge over the years. If you are diversified on the short side, you can find investments that will crash hard in bear markets but won't outperform to the same degree in up markets -- everyone that has shorted a stock knows that it hurts far worse to hold short a good but overvalued company through a "better than expected" earnings report. In fact, it hurts far worse than a cheap stock on your long book falling due to a panicked seller or small earnings miss. The reason being that when shorting a stock, new developments can change your thesis, forcing you to cover at a loss. The same can happen on the long side, but when you invest with substantial margin of safety, most price drops do not reflect a decline in the investment's intrinsic value.

Many times ETFs are a good way to hedge a long book through the buying of deep in the money put options (I am using this technique on the Russell 2000 currently) and either selling front month ATM puts against them, or using this position as your defacto short book. Either way, the risk of an upside shock or breakout rally on your short book is much lower when implementing put buying (a strategy with limited profit and limited loss built in) than shorting stock outright when the VIX is this low. If you buy a deep in the money put option, the Delta quickly matches the short position and requires a much smaller investment than an outright short position (which unless you collect a short rebate, this strategy can sometimes lower margin costs) and provides virtually the same benefit.

Another strategy on the short side is buying in the money puts on overvalued triple leveraged ETFs in the notional amount that you want to hedge. Several benefits accrue from this technique as the leveraged ETFs mostly contain large tracking errors due to their stated daily return objectives so that they underperformed their 3X return objective over a longer period of time. So, one would basically decide the amount they wanted to short/hedge versus the Russell 2000 and would buy 1/3 of that notional amount of the TNA in the money put options. If you are looking for income, buying the long dated puts and selling the near month puts is another option.

Right now, I am nearly fully hedged in equities into the new year. That said, I do have some commodity exposure and some farmland exposure right now which I feel pretty good about. If the market is as overvalued as I think it is, the farmland and commodities should perform well as the government is forced to print more money. It's a strange time politically and economically, and to think that everything is "Goldilocks" again is premature.

When the last bear turns bullish, and only when the voice of the stock market bear is completely silenced, the turn for the markets will be made -- I am not convinced that now is the time to sell everything, just that I will be sticking to some macro themes, such as hard assets and farming and having hedges in place. Once we have a meaningful correction, I believe the 110% Long 40% short strategy invented by A.W. Jones is the best way to invest in the markets, along with keeping an eye on option premium so that when prices for options are high, one sells theta and premium and vice versa.

Specific shorts here include Chipotle Mexican Grill (NYSE:CMG) short and short calls, OpenTable Inc. (NASDAQ:OPEN) (short Jan $55 call, long put spread), Lululemon Athletica (NASDAQ:LULU) (short the Feb $75 calls), Salesforce.com (NYSE:CRM) (short $135 and $140 calls long puts)

Disclosure: I am short CMG, CRM, OPEN, LULU.