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For the last month I have heard the same thing from my friends and acquaintances in the Financial Adviser industry. They collectively hate these times, their phones ring with panicked clients, money is being lost by the day, and the only comfort they can offer is “We are all in this together.” Of course and unfortunately most Financial Advisors can only think about the “Long” side of the equation. For the most part they have plugged-and-chugged the clients “profile” into a model and it allocates their money into an array of mutual funds and investments (all long) to create the “model portfolio”. All this is great if the market is going up, but what happens when the market falls out of bed and volatility gets jacked? Well those “model portfolios” frankly looks like shit.

Courtesy of US NEWS

The real problem is NOT your Financial Adviser. I know plenty and they are smart guys and gals and seriously want to do the right thing. The problem is they are handcuffed to some corporate “model” that is based on acquiring assets under management. They are certainly NOT encouraged and in many cases forbidden to wander off the “model portfolio” reservation.

Yet those that do to expand their knowledge and offerings, by going independent have been able to bring something that the vast majority can’t even begin to fathom and that is to make money in a collapsing high volatile market.


If you know me or have followed the Market Preview over the years, you would know one thing – better hedged than dead.

The Poker Mind
I akin the thought process much like playing poker. We have all (or should have) played poker. The key in poker is to understand risk vs. reward ratio, essentially the probabilities of winning vs. the capital risk (pay to play). Usually the smartest thing to do is eventually fold. To know when to fold is what separates the winners from the losers.

Courtesy of wiki

The market is the same, unfortunately most people do NOT know when to fold. My grandfather once told me the only decision you make BEFORE you buy a stock is what price you are going to sell it for to profit and how much of a loss are you willing to take if it falls. If you are not going to sell it, then you must want to hold it forever – otherwise there is no reason you should have bought it to begin with.

Psychological Problems

Most investors never think of the exit price. They buy it with no goal other than hope that it will appreciate. They certainly haven’t thought of how much of a loss they are willing to take. I remember one investor who was so damn adamant about Enron, he kept buying more as it fell. He had NEVER EVER set a loss limit for himself and also never had an exit price if it were to rise. In the end he lost well into the 6 digits.

When I used to instruct and lecture on risk management and hedging one of the most common and frankly idiotic question I received was; “If the stock has fallen and I have an unrealized loss, how do I make back that loss?” – my answer is YOU DON’T! You made a bet, you were wrong, move on. People just can’t seem to understand is that you are only as good as your last trade. The problem is psychological; they can’t come to terms that they have to take a loss.

The other psychological problem is that society has been trained to believe when the market is going up it is a good thing and when it goes down it is a bad thing. What we should think about is our positions ability to profit as it relates to market direction. If your position is bearish, then the market going down is a good thing. When I was a market maker on the trading floor I remember friends (not in the market) mentioning seeing the Dow Jones up big and said you probably had a great day, when in reality I may have been short and taking losses. More frequently I hear from friends and acquaintances when the market is dropping that we must be losing, and when I tell them we are doing great they can’t FATHOM the idea that we are profiting in a collapsing market. Our KFYIELD FUND made a profit in January and frankly people just don’t understand how we could do that, especially since we are long equity positions.

Long and Wrong!

It all comes down to hedging and if you are not hedged, you are just “Long and Wrong!” Fortunately for me my foray into the financial markets started on the options trading floor of what is now the NYSE/ARCA exchange in San Francisco. As I moved up from working for the exchange as a clerk, then an institutional floor broker, and eventually market maker – my world was only options, hedging, risk, Deltas, Gammas, Theta, Rho, Vega, etc. For me any stock position that was NOT hedged with options, regardless if long or short was considered “NAKED STOCK”. “Naked” meaning you are unhedged. You would certainly be considered a fool if you were “Naked” Long (or Short) a significant amount of “Hard Deltas” (equivalent stock). Because people knew it was only a matter of time before you were going to take a massive loss and be out of the game.

Courtesy of the CBOE

That is not to say we didn’t take long or short bets in the market, we did – but we did it with predefined amounts and used GAMMA rather than Hard Deltas to profit in directional plays. For us, we measured risk in the cost per Gamma if we were to take a directional play. This is frequently known as taking “soft deltas”. They didn’t hurt that bad if you were wrong.

For the layman, all we were doing was insuring every position at all times and limiting our risk exposure to very predefined levels. We either made money from collecting premium or making very limited calculated directional plays (Long Gamma and Soft Deltas).

How do you Hedge?

How do we do it? In the simplest of terms, we buy puts that allow us to sell our long stock for a given price on or before a given period of time. In essence it is an insurance policy that has a deductible and premium. When I bring this basic strategy to investors and/or financial advisors they almost always say – “but you have to PAY a premium to insure your stock and that eats away at your gains!” If I was still on the trading floor with my “no-holds-bar” Navy Vet mouth – I would say – “Yeah, no shit – you just figured that math out yourself?” I would probably have added a few more expletives in there, but I think you get the point. The good old days as a floor trader combined with being a Navy Vet is something I certainly miss. Suffice to say, yes – you will pay a premium to do this. However, what makes little sense to me is that these same people buy health, auto, home, life insurance and have no problems writing those checks knowing it not only protects their health/life/property but in the case of property it secures it from losses as they HOPE it gains in value.

Most investors that I encounter have far more money invested in the financial markets than the net worth of their home. While they don’t have problems paying insurance premiums for their home, to convince them of insuring their investments is an up-hill battle. It makes little sense.

While I have certainly simplified the hedging method of buying puts, there is far more too it. I wrote a book on using options (Fundamentals of the Options Market – by McGraw Hill) and have lectured on the subject to the SEC, OIC, Universities, and investment firms across the country. I don’t lecture too much anymore, other things have occupied my time, yet I recommend you get a book, take a course, and learn how to INSURE your positions. Because if you don’t the market determines how much you make or lose.

Don’t get me started on “Stop-Loss” orders, aka the “pseudo hedge” because in a gapping market they don’t work. I also don’t like the market determining when you take a loss, which is what a stop loss order is.

A real HEDGED fund!

Courtesy of KineticFunds

I felt so strongly about using options to hedge a portfolio that we started a fund (KFYIELD) that does just that. The first goal and mandate of the fund is to protect the investment from substantial losses. The second mandate is to generate income. The third is to offer liquidity. We have built a four-year track record and in late 2015 we started marketing the fund.

As I have never been in the retail or fund raising space, this is a new experience and I frequently encounter investors asking me the oddest questions like “Do you guarantee profits?”, “What happens when the fund losses money?”, to name a few.

There is no such thing as guaranteed profits and when the fund loses money, it loses money. I seriously do not know how to answer these questions. What I can tell them is how much money is at risk at anytime (note: always less than 10%). I can tell them how we profit IF the market declines. I can tell them what our risk/reward ratio is. I can tell them we do not rely on HOPE the market goes up. Frankly, there is no such thing as a guarantee, ask people who invested in AAA bonds, Freddie, Fannie, GM, Money Markets than went negative, even muni bonds that have failed or taken a haircut. What we can confirm is the guarantee of our risk profile.

My goal is clear – to hedge against adverse market conditions and even potentially profit. No one knows what tomorrow holds. The market COULD go up or go down. My job is to make sure that we limit our losses so we can profit tomorrow.

The investment game, much like poker, is about sustainability. Am I positioned so that I can be in the game tomorrow?

Want to know what I think about the market? I think it will remain volatile and for now I will remain hedged and participate. Our KFYIELD Fund profited in January, why? Because we were over hedged (over-insured) because the market was volatile. These are the times in which we do well and our investors are happy they are not “NAKED” long the market, hoping it will rally to make back losses.

Traders Advice!

It certainly looks like we are putting in a double bottom at these levels. I would take some long gamma and long “soft” deltas in here. We could see a covering rally out of these lows. However, this is NOT a trend or a recovery – this would be a fast moving upside rally in a TRADERS market. A break-out rally out of the double bottom will certainly hit resistance back at the previous Feb 2nd highs. That would be the test if it could break through and move higher, but that is where I would take profits from long gamma / long soft delta play. I would get flat deltas and make sure I have gamma for another move higher or lower. Conservative is 1:1 Long Delta to Gamma Ratio. Want to get aggressive in the lows, I would go 3:1 Long Delta to Gamma. However, make SURE you know your delta bias before you take deltas.

Support & Resistance

INDU 16,000
The Dow Jones was slammed yesterday, but rallied back to and above the 16,000 level. The market is paying close attention to the 16,000 level to see if we can hold there. The pre-market futures are showing another move lower. Watch the close and 15,800 is support. For a double bottom, I would look to 16,400 for resistance on a bounce and get flat deltas at that point.

NDX 4000
The tech heavy index fell out of bed. It broke below that 4000 level and the pre-market futures are looking weak. We need to see a close back above 4000 if we are to expect any support. This index makes the 4100 long bottom pickers want to puke. However, I think a move back to 4100 or 4200 is in the cards on a covering bounce. Get flat on that move up – if we get it.

SPX 1850
Watch the close, we need to see some strength this week and some consolidation in the 1850 level to see a rally. I would look to start getting flat deltas on a bounce to the 1900 to 1920 range. If we break lower, I would maintain long gammas and a 1:1 long delta to gamma ratio.

RUT 980?
The one index that gives me little hope of any sustainable rally in the short-term is the Russell. I have said – for years – this is the best indicator of money flow into or out of the market. Right now it doesn’t look good and I have yet to see any support.

Fueling the Sell Off?

What is fueling the sell-off is margin calls. I have been watching the NYSE margin index, which recently hit an all-time high, is now coming off sharply. Investors can’t hold positions on margin and we are seeing forced liquidation.

I also expect the Fed to ramp up stimulus and negative rates (like Japan) is still in the cards. I don’t see the total implosion happening yet – the Fed can still buy time, perhaps a year.

One Response to “Hedging?”

  1. McRocket says:

    Thanks for this.

    Unfortunately, I fear the Fed can buy a LOT more time then a year. Japan – granted under different circumstances – has managed to keep the spinning plates in the air for about 25 years. Plus, the Fed still has negative interest rates, more QE, direct stock purchases (like the BOJ is doing now) and even could purchase companies directly (like when they – in essence – purchased AIG).
    I think the sooner the inevitable collapse, the better for all concerned.
    But I fear the Fed can drag this thing out for 3 or 5 or even more years. Personally, I predict it will be at least 3 more years.

    I sincerely hope I am wrong.