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Author: mungofitch Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 253116  
Subject: Re: Jim's S&P future hedge Date: 6/23/2014 4:58 PM
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If markets keeps rising, the accumulated quarter losses might require a deep pocket
for a retail investor. The market can stay irrational longer than you can stay solvent.


Indeed.
This is a strategy that makes cash evaporate at an alarming rate while the market rises.
It follows that you need the cash to cover that requirement.

I have a big pile of cash in relation to my portfolio size.

So, though the hedge losses have not been fun to watch, it's within anticipated bounds.
Plus, I still have more longs than shorts, so I could always sell something.
Provided my longs roughly keep up with the market it's not a problem for net worth.
The only really inconvenient point is if I get to the point that I
feel it's time to sell a long to raise cash to cover losses on the short.
I don't mind selling things, and they would probably be pretty fully valued
by that point, but it would leave me less net long, a mixed blessing.

There are two main ways to look at it.

You can think of it as an isolated trade. In that sense, we don't know whether
it's a successful trade unless and until (a) I give up, whether due to emotional
weakness or running out of cash pile, or (b) I close it for a profit.
Presumably one of those two things will happen eventually.

Or, you can think of it as a hedge. In that case, as with ANY hedge,
the secret is to ignore the profit and loss of any one side individually.
It's the sum of the two that matters, so track that.
I'm up quite a bit year to date overall. Does it matter so much which side of the portfolio that came from?

In the end, I don't think the losses from the hedge side will be insurmountable.
The broad US market isn't going to keep rising at 20%/year forever.
Given elevated valuation levels it seems reasonable to expect as many
downs as ups in the next several years, just in an unknown order.

I guess my overall portfolio can be thought of as three legs.
Say, $3 of Longs. Market down I lose -$3, market flat I'm flat, market up I make +$3.
Smaller index short. Market down I make +$2, market flat I'm flat, market up I'm down -$2.
Put writing. Market down I lose maybe -$0.60, market flat I make +$1, market up I make maybe +$1.20
Disaster puts (deep out of the money index puts I've purchased), a loss of -$0.10 in all common scenarios.
The sum of those, assuming it's not a drop big enough to make the disaster puts pay off:
Market down I'm down -$1.70
Market flat I'm up +$0.90
Market up I'm up +$2.10

If the market drops more than a little bit some non-linearities creep into it, so it becomes more of an educated guess.
I have some "disaster puts", and a lot of my longs are held as deep in the
money calls which start losing money more and more slowly as prices fall.
So, maybe if the market REALLY tanks maybe I'm down maybe not much more than during a moderate fall.
This would get very volatile for a while in terms of market value, but no margin calls.
The index shorts throw off cash at a correspondingly furious and immediate rate
as the market falls, and the disaster puts could be liquidated very profitably,
leaving lots of cash to go shopping for bargains.

Is this all a good idea?
Beats me. But I make money or at least break even in a lot of different scenarios,
and don't lose more than I can handle in any outcomes that I can foresee.
(barring problems like asteroid strikes which are not amenable to solution via financial engineering)

The ideal outcome for me based on that positioning is
(1) the market tops out at some point,
(2) then it falls quite a bit (but my longs falling less) over a period of time,
(3) then I close the short index futures positions for a nice profit
(4) I use those profits to add to my longs which should then be cheaper
(5) (presumably then the market falls a while longer, Murphy's law, but I ignore it),
(6) maybe I can close some of my disaster puts for a profit depending on how far/fast things go,
(7) then the market eventually recovers to this level or better.

I make a one-time profit on the shorts, and another profit on that
same capital from the rebound in the longs I buy while they're on sale.
Alas, there are other possible trajectories, but that would be ideal.

In fact, the best for me is if it all happens quickly: a gigantic obvious crash to a very low value right away.
That way there is no difficulty deciding when to close the hedges!

Jim
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