In the last article, I discussed a simple strategy for hedging out macroeconomic risks in a particularly turbulent market. However, the market neutral equity strategy described has a very serious risk implication on its own. Specifically, a market neutral equity strategy requires a situation in which the hedged out macro-risks out-weigh the company specific risks with the associated position.
If that balance is not struck, the investor is bound to lose money from a growing spread. Because analyzing company-specific risks can be a somewhat time-consuming pursuit for a personal investor, I’m going to dedicate the next two articles to a couple of strategies for hedging macro-risks, while restricting company-specific risks to a single institution.
The first strategy I’m going to outline for hedging macro risks from within a single company is called a Long Call, Market Neutral position. It is an options transaction that involves purchasing a long Call on equity, and then selling another call short at a higher price. Both options are for within the same period, and so the end result is that you are covering a cheaper position that is far out of the money, with a call that is generally in the money. The end result is that you will realize a profit as the position increases, but you will have hedged a small portion of your downside risk.
The trick to managing this position is making sure that you have selected two positions that will properly accommodate each other. On the one hand, a position that is deep in the money provides you a greater company-specific protection, however, it will also be more expensive. Alternatively, a short position that is further out of the money will have a greater upside potential, but will provide less of a hedge against macro-specific risks.
However, the ability to choose from different breadths of protection allows you as an investor to specifically tailor the position to suit your needs. From there, it’s easy for you to work together with your advisor to find out what kind of exposure you’re willing to take on.
As a quick final note, it’s also interesting to notice how this account can fit into your investing time horizons. If you have a long-term horizon, but are concerned about a macro-event that might require you to extend that timeline, you can build in a macro-hedge to specifically mitigate those risks over the short-term, while still maintaining your goals.
However, this position still requires that you put money on the table, and also assumes there will be a rebound in the price afterwards. In the next article, I’ll show you how the position could be reversed, so that you can actually benefit from the short-term downside.
