Just realized I made a slight data entry error in my hedging example in my previous comment ( http://seekingalpha.co... ), but it doesn't change the results materially. The cost of hedging against the drop described above should have been $749, or 0.749% of position value.
I would agree that, if you believe the market is going to decline, holding a large cash position shouldn't be considered a liability. But if you are confident that the market is going to decline in the near future, you could simply bet against it rather than holding cash or hedging; holding cash and hedging are both ways of handling the uncertainty of not knowing what the market is going to do in the near future.
You are right that holding cash constitutes an opportunity cost if the market goes higher, and that (unless you are able to roll them before expiration), protective puts would expire worthless in such a situation. But given the current, low cost of hedging against market risk with optimal puts, the hedged investor may still be better off in this case. Consider the following example.
Let's say there are two investors, Investor 1 and Investor 2, and Investor 1 decides to hedge against a greater-than-20% drop in the Dow between now and late December using the current optimal puts for that. Adjusting for the odd lot a $100k position in DIA includes at the moment (the app does this automatically) this would cost him 0.74% of his portfolio (that cost is calculated conservatively, assuming he bought the puts at the ask price; as you know, an investor can often buy puts for less, i.e., some price between the bid and the ask). Let's say Investor 1 has a $100k portfolio, so after buying those puts he has $99,202 in equities and $798 in his protective puts.
Now, let's say Investor 2 also has a $100k portfolio, and rather than buying protective puts to hedge, he holds a 50% cash position. So he has $50,000 in equities and $50,000 in cash.
What happens to both investors' portfolios if the market appreciates by 10% between now and late December? Let's assume, for simplicity's sake, and to be conservative, that Investor 1's puts expire worthless. His $798 in protective puts is now worth $0, and his $99,202 in stocks is now worth $109,122. So, his total portfolio is now worth $109,122. Meanwhile, Investor 2's $50,000 in stocks is now worth $55,000, and his $50,000 in cash is worth perhaps $50,200 (given the current paltry money market rates) so his total portfolio might be worth $105,200. Of course, if the market were flat over the same time period, the investor holding the large cash position would come out a little ahead.
I also agree that the market today is not analogous to the Nasdaq in 2000 or the Nikkei in 1989, but I think it may be analogous to the market in 2007. The market is significantly overvalued according to some measures (such as Tobin's Q Ratio, for example), and there are other troubling indicators, such as brokerage margin debt being at record levels.
Also, if you believe the current bull market is a cyclical one within a secular bear market (as I do), then you may be concerned that the cyclical bull market has gotten a little long in the tooth. And I believe there is utility in hedging against steep declines when it's inexpensive to do so, even if it may be possible to eventually recover from those declines by gritting it out, as it were. Being hedged during a bear market doesn't only limit losses but give an investor dry powder (the cash value of his appreciated hedges) that he can use to pick up bargains.
Cost is certainly a concern when hedging, but as I mentioned the cost is fairly low to hedge against significant declines in the Dow right now. That's true for investors using smaller decline thresholds as well. For example, the current cost of hedging against a greater-than-15% drop in the Dow between now and late December is about 1.19% of position value. And it's worth noting that this sort of hedge can, in some cases, also ameliorate smaller declines.
You're right that an investor is faced with decisions about expirations and strike prices when hedging with protective puts, but our research suggests that options with approximately six months to expiration tend to offer the best combination of cost, liquidity, and convenience from the investor's perspective, so our app aims for those. The app also shows the investor the specific options which will give him the level of protection he wants at the lowest possible cost, so it simplifies the process of hedging.
One benefit of hedging is that it can obviate the need to hold a large cash position. There are, as you know, opportunity costs to holding large cash positions.
As for suggestion that "corrections tend to be short lived and recoveries tend to be certain," this is generally true during secular bull markets. If you believe we are in a secular bull market now, that is reasonable advice. But I believe we are in a secular bear market that began in 2000, and won't end until valuations are much lower than they are today.
Unhedged investors who were long the Nikkei in 1989 or the Nasdaq in 2000 have been waiting a long time for those indexes to recover their all-time highs.
That lack of volatility makes it quite cheap to hedge now. I showed a way of hedging against a significant drop in the Dow in this instablog post earlier this month: http://seekingalpha.co...
Checking the numbers as of today, it's even cheaper (slightly) to hedge now.
Pricing Apple's Uncertain Future: A Scenario Model [View article]
No question, the market is addicted to growth, particularly when it comes to tech stocks. If you are long AAPL and you want to add some downside protection here, we looked at a couple of ways of doing that in this instablog post last week: http://seekingalpha.co...
Japanese shares end +0.6% following a volatile session in which stocks rose and fell by over 3% vs the close yesterday, when they slumped 7.3%. The plunge on Thursday was "just a speed bump" given this year's strong returns, says U.S. fund manager Audrey Kaplan. Improving economic conditions "will support the market going forward." Hong Kong flat, China +0.6%, India +0.3%. [View news story]
For longs who decide to hold ARMH regardless of those catalysts, I showed a couple of ways to hedge the stock in this instablog post earlier this week: http://seekingalpha.co...
Those gold buyers would have more money to buy gold with today had they hedged GLD earlier this year. I showed a couple of ways to do that, back in January, and wrote this follow up Instablog post on it last month: http://seekingalpha.co...
"I'll take 'Kiss of Death Magazine Covers' for minus 7%, Alex," tweets a clever fellow as this week's The Economistcover shows Japan PE Shinzo Abe flying through the air like Superman. DXJ -6.9% premarket. [View news story]
I showed a couple of ways to hedge the MSCI Japan Index ETF EWJ in this instablog post last week: http://seekingalpha.co...
Thanks, but bear in mind that what I've described above isn't roulette. There are, broadly speaking, two ways of using options -- speculation ('roulette') and hedging (insurance). The examples above are of insurance.
Cisco's Price Correction Is Far From Over: Part 2 [View article]
For CSCO longs who may want to add some downside protection now, I showed a couple of ways to hedge it in this instablog post today: http://seekingalpha.co...
Diana Containerships Business Model Continues To Deteriorate [View article]
That's an interesting theory re how DSX might be using its loan. I haven't been following DSX closely, but I took a look at the cost of hedging it today and noticed something interesting. If you're willing to cap your potential upside at 20% over most of the rest of the year, the cost of hedging DSX against a greater than 20% drop over that time frame is pretty inexpensive. I showed the optimal collar for that in this instablog post: http://seekingalpha.co...
That Was The Crash, Dummy [View article]
That Was The Crash, Dummy [View article]
You are right that holding cash constitutes an opportunity cost if the market goes higher, and that (unless you are able to roll them before expiration), protective puts would expire worthless in such a situation. But given the current, low cost of hedging against market risk with optimal puts, the hedged investor may still be better off in this case. Consider the following example.
Let's say there are two investors, Investor 1 and Investor 2, and Investor 1 decides to hedge against a greater-than-20% drop in the Dow between now and late December using the current optimal puts for that. Adjusting for the odd lot a $100k position in DIA includes at the moment (the app does this automatically) this would cost him 0.74% of his portfolio (that cost is calculated conservatively, assuming he bought the puts at the ask price; as you know, an investor can often buy puts for less, i.e., some price between the bid and the ask). Let's say Investor 1 has a $100k portfolio, so after buying those puts he has $99,202 in equities and $798 in his protective puts.
Now, let's say Investor 2 also has a $100k portfolio, and rather than buying protective puts to hedge, he holds a 50% cash position. So he has $50,000 in equities and $50,000 in cash.
What happens to both investors' portfolios if the market appreciates by 10% between now and late December? Let's assume, for simplicity's sake, and to be conservative, that Investor 1's puts expire worthless. His $798 in protective puts is now worth $0, and his $99,202 in stocks is now worth $109,122. So, his total portfolio is now worth $109,122. Meanwhile, Investor 2's $50,000 in stocks is now worth $55,000, and his $50,000 in cash is worth perhaps $50,200 (given the current paltry money market rates) so his total portfolio might be worth $105,200. Of course, if the market were flat over the same time period, the investor holding the large cash position would come out a little ahead.
I also agree that the market today is not analogous to the Nasdaq in 2000 or the Nikkei in 1989, but I think it may be analogous to the market in 2007. The market is significantly overvalued according to some measures (such as Tobin's Q Ratio, for example), and there are other troubling indicators, such as brokerage margin debt being at record levels.
Also, if you believe the current bull market is a cyclical one within a secular bear market (as I do), then you may be concerned that the cyclical bull market has gotten a little long in the tooth. And I believe there is utility in hedging against steep declines when it's inexpensive to do so, even if it may be possible to eventually recover from those declines by gritting it out, as it were. Being hedged during a bear market doesn't only limit losses but give an investor dry powder (the cash value of his appreciated hedges) that he can use to pick up bargains.
That Was The Crash, Dummy [View article]
You're right that an investor is faced with decisions about expirations and strike prices when hedging with protective puts, but our research suggests that options with approximately six months to expiration tend to offer the best combination of cost, liquidity, and convenience from the investor's perspective, so our app aims for those. The app also shows the investor the specific options which will give him the level of protection he wants at the lowest possible cost, so it simplifies the process of hedging.
One benefit of hedging is that it can obviate the need to hold a large cash position. There are, as you know, opportunity costs to holding large cash positions.
As for suggestion that "corrections tend to be short lived and recoveries tend to be certain," this is generally true during secular bull markets. If you believe we are in a secular bull market now, that is reasonable advice. But I believe we are in a secular bear market that began in 2000, and won't end until valuations are much lower than they are today.
Unhedged investors who were long the Nikkei in 1989 or the Nasdaq in 2000 have been waiting a long time for those indexes to recover their all-time highs.
That Was The Crash, Dummy [View article]
Checking the numbers as of today, it's even cheaper (slightly) to hedge now.
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Pricing Apple's Uncertain Future: A Scenario Model [View article]
There Goes Tokyo [View instapost]
Japanese shares end +0.6% following a volatile session in which stocks rose and fell by over 3% vs the close yesterday, when they slumped 7.3%. The plunge on Thursday was "just a speed bump" given this year's strong returns, says U.S. fund manager Audrey Kaplan. Improving economic conditions "will support the market going forward." Hong Kong flat, China +0.6%, India +0.3%. [View news story]
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"I'll take 'Kiss of Death Magazine Covers' for minus 7%, Alex," tweets a clever fellow as this week's The Economist cover shows Japan PE Shinzo Abe flying through the air like Superman. DXJ -6.9% premarket. [View news story]
Downside Protection For Cisco Systems [View instapost]
Downside Protection For Cisco Systems [View instapost]
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