Volatility went through the roof again this week, and to be honest, I can’t even keep track of it any more. Between the political deck-shuffling in Italy and Greece delaying any semblance of sanity in the debt markets, and a sudden re-emergence of conflict in the middle-east stirring up the commodities, I find myself incorporating increasingly more complex hedging strategies into my analyses.
So with this week’s madness as inspiration, I’m going to describe a couple of simple hedging strategies that you can use to generate more free cash flow from your positions, and better secure your returns over a set period of time.
The first concept I’m going to demonstrate is the use of options to enter a position. This can be accomplished in two ways. Firstly, you can purchase a call option, which places you in a position of control over your exposure, but at a cost against cash flow. In purchasing a call option, you limit the amount of cash required upfront to take on a position. However, you still need to pay out a small amount of funds to enter the position, and this amount is generally 100% at risk.
Back when I was studying finance in university, I had a small group of friends that would have competitions to see who could make the greatest returns on the lowest amount of risk, and the most memorable returns always came from this class of position.
However, the pricing models associated with pricing options (which I’ll get into a little bit later) are usually complex enough to take into account the short-term volatility associated with the underlying asset associated with your contract. What does this mean? It means that purchasing a ‘naked’ call option is kind of like declaring yourself capable of doing math better than the quantitative analysts at whatever hedge fund is selling you the option. This turns options purchasing into a game of competitive computer programming, one which is beyond the grasps of the personal investor. Let me show you a more practical way of purchasing calls to better suit your needs.
Suppose an investor owns XYZ company in their portfolio, but the market is down that week on news of some short-term event (let’s say, something like a shuffle in European parliament). The investor originally purchased XYZ at $10, and it is currently at $5. The investor’s trusted advisor is confident in the ability of the stock to reach a price of $15 by the end of the year, so long as the investor can remain brave enough to stomach the macro-volatility of the short term.
Normally, this temporary dip in the price presents a very strong buying opportunity to ‘average-down’, and therefore earn even greater returns on the asset come the end of the year. However, averaging-down in this situation requires the investor to buckle-down, and spend hard-earned dollars on stocks instead of bills. This isn’t a safe situation, and should be avoided at all costs. For all we know, XYZ may stay at $5 until the eleventh hour of the eleventh month before it finally moves up to its $15 target, leaving our poor investor cash-starved for a full year!
The solution is simple. If the investor is already exposed to XYZ, and wants to average down their cost base, they can simply purchase a $10 call contract for a 12 month period. The position will cost less than 10% of that associated with actually entering the position, but will retain the same upside exposure as buying the stocks themselves. The investor is therefore able to take advantage of the short-term discrepancy, and also benefit from the tax advantages of a lower cost base. Lastly, their full exposure to the upside of the stock is greater, but with a minimal amount of incremental cash-risk.
Sounds like a good idea right? It is, but it still requires an investor to make that dreaded buy-commitment. There’s money at risk on the table, and we don’t like that. What if I told you there was a way to set up the exact same position in a way that instead paid-you for your exposure? In the next article, I’ll show you a clever way to be paid while you wait out short-term discrepancies.
