Monday, April 14, 2014

Buying Protection

This strategy has always cost me money rather than saving money or better yet, making money. Ideally, I would like to hedge my portfolio with a protection instrument that would offset my losses in the portfolio to make sure that my overall quarterly performance does not take a beating every time the market decides to have a panic attack.

The easiest ways I have come up with are the following:

1. Buy puts on individual shares (refer my last trade for lessons learnt :-))
2. Buy puts on S&P (Kicking myself for not doing that inspite of a thesis of market direction)
3. Buy double/triple short ETFs for markets indicies
4. Buy VIX or options on VIX (By first experiment with protection)

I have to say that I have tried all these strategies to varying degree, but to little success. The have little faith in (3) and (4) because as I track these instruments I find that there reaction to the negative side is far more violent compared to their trends to the upside. When you buy an instrument you would expect to have a symmetrical instrument, but the short ETFs are not for the faint of heart. When the market tanks, it does trend up, but when the market goes up, these instruments really take it to their chin. Seems like people have more confidence in their negative trend and are too nervous holding it than owning it. The same can be said about the VIX. During the Great Recession, the VIX was a great indicator and I did play it a few times, but now I see that the VIX has become a poor indicator, again carrying a bias to the negative side for the trade that it provides.

For (1) I think I have already harped enough. The key is to make sure you have a thesis on the stock and play the thesis rather than getting too aggressive or too safe on the bet. A hard balance to strike. But the key is to have the conviction and go for it without overplaying it. So I do think there is some merit here if your conviction is high.

Which brings us to (2). This is the one I am yet to play, to my own surprise. After all isn't this the most obvious way to protect yourself? I would think so, with the assumption that your portfolio is diversified enough to be represented by S&P. Having said that I have not yet devised an effective way to play the short side of the index. Should I buy a 2 year put on S&P when the market is really roaring, and keep it as protection was the rainy days? When do I sell it and get out? When do I I roll into a net option as the current one ages?

Here is a theory (and I am yet to try it)

Buy put options three years out, when the market is up 10-20% and hold it for the first year. If you have a 10-15% correction, sell out of the options (and this is where you get exposed to further downside) and buy into the options again when the market turns up by 10%. The other option is to hold it till expiry if you are in the money and get exposed only when you have to sell it. In either case, the key here is to buy it when things are rosy (like Jan 2014) and sell out in times when the market is looking hopeless. Even if you don't get it perfectly right in the timing, as long as you get the general direction right over a period of 2 -3 years you would have protected your long portfolio to some extent.

Having said all this, I find the short trade a very hard one to play due to the time restrictions on the trade. Best would be to research the long side and accumulate it as the market swoons to reap it when the fundamentals have finally played out.

But then, where is the fun in that, right?

Saturday, April 5, 2014

So close yet so far

I am sorry for harping on the same trade again, but there are two reasons I publish this post.

1. To claw back some self respect for the losing trade that I made on FEYE a month back
2. To explain why the adage "Market can stay irrational longer than you can stay liquid" is a lesson in humility and something that should never be forgotten.

Yesterday, FEYE hit 50$. This is a good 10$ below my target price for the short trade I had proposed a couple of months back. And true to the calculation, FEYE is heading back to a valuation that is closer to 10 times revenue like its peers. If you compare that with the chart for PANW, PANW has been able to hold on to the levels that it was at when I wrote the first post about this since it was already hovering around 10 times revenue. Needless to say that the slump in the market is slowly becoming a reality with all the momentum stocks taking it to their chin in the last couple of weeks. So in summary I take solace in the fact that the thesis on my trade was intact.

Now for the second lesson and the more important lesson. I played an aggressive hand on this trade. Though my thesis said that the slump would be here by summer, my trade tried to get ahead of that thesis and got into a time horizon that was way more aggressive than my own thesis. Instead of buying the march puts, if I had stuck to the thesis of May time horizon, I would now be in the money on that trade by 20$ that translates to 2000$ per option.

On that note. I shall close the chapter on this trade. Lesson learnt!