Posted: February 10th, 2009 | Author: Wayne Weddington | Filed under: Opinion | Tags: market meltdown, market volatility, Strategy, Volatility | 
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Most of the financial news outlets are posing the question: keep stocks or sell?
The opportunities transcend the binary choice of liquidating your portfolio or simply holding on for dear life. No doubt about it, the next twelve to eighteen months are going to be volatile. I think the general trend will be weakness but there will be flashes to the upside as well. A few months ago the Dow had a +9.0% day which was huge. I was impressed, only to find out that it was merely the sixth largest in history. The other five times occurred in the period 1929 – 1933, in the wake of the Great Depression.** So expect big down days and big up days occasionally. Volatility.
In Do-it-Yourself Hedge Funds I discuss opportunity thinking. In other words it is a way to take today’s news and turn it into actionable market opportunities. It is not a secret sauce but provides a starting point for your strategy objectives and implementation.
There are infinite possibilities that could yield desired results for the current year, but they will all likely derive from high volatility, and declining fundamentals, both economic and company-specific. For example, if you have a portfolio of blue chip stocks, selling volatility premiums against it is not a bad idea. The VIX has been hovering between 40 and 80 which allows the average investor to sell “volatility premiums” to the market. Yes, it could limit the upside, but if you look at the equity markets since October 2008, they have been trading a fairly tight range. Selling premia is a way to capture that vol as cash until there is a breakout either way.
You should also think of pairs trades, especially for individual securities versus their peers individually or the sector at large. For example one thing I noticed, going into the fourth quarter of last year, is that McDonald’s (MCD) and Walmart (WMT) performed relatively well for then year-to-date, despite the prevailing predictions of gloom and doom. Part of the reason is that these companies, while categorized as Consumer Discretionary companies, really trade like Consumer Staples in tough times. When dollars are tight, people go to McDonald’s and Walmart to stretch their dollars. Sad that MCD behaves as a Consumer Staples company. But true.
Rather than take a naked buy on these companies (even they are laying off and experiencing declining performance), a relative-value trade would have provided significantly more return and arguably less risk. A “pairs trade” of buying MCD and WMT while shorting the broad retail sector (such as XRT, the S&P Retail Sector ETF) generated a relatively stable return (>40%) in 4Q 2008. That may seem like 20/20 hindsight but, believe me, there were many hedge strategists in that trade and others that reduced full market exposure while taking advantage of relative performance. The narrative for this trade was derived from simple daily news.
I said in an earlier post that these markets require extraordinary measures. Yes, it would seem right now that the only thing better than money is cash. But also keep an eye out for the opportunities that manifest themselves by very virtue of the toxic mess into which we have gotten.
-Wayne Weddington
** I recalled these market stats from memory.. they may be approximate.
Posted: December 1st, 2008 | Author: Wayne Weddington | Filed under: Strategy | Tags: covered calls, covered puts, market meltdown, market volatility, synthetic options | Email This Post
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It is not only the market traders who share the anguish caused by the market turmoil. one friend writes:
“I think I should write an article too but from the standpoint of the wife of a hedge fund manager. I never thought that I would spend more time focusing on the “market” than anything else around us. I wake up with CNBC, I go to sleep with CNBC. Our life-style, our kids’ future, our home, vacations, my sanity! depend on “the market”, this absurd, violent ‘thing…’
Most investors and traders have taken a beating this year. As the market whipsaws to investors’ need for liquidity, or to run for the hills, or day-trading, or, yes, to double down, there have been few winners.
With a hint of fear and trembling in their voice, I have been asked many times over the last few months about what to do next in the market. It usually goes something like this: “my [wife] [husband] [f buddy] [domestic partner] [girlfriend] [boyfriend] [lover] [friend with benefits], one of the scared-y cats, is very nervous about the markets… a friend suggested selling everything, take the loss, and re-buy other assets (after the 31-day limit) or buy a call option to avoid missing any bounce-back… what do you think??”
Hm.
Well first of all, there is no absolute answer, because ten people in a room could all have a different path based upon their own capital needs, near-term and far. But there are some things you should not do.
I am not a fan of free investment advice, so please take my own advice with healthy skepticism. There are many voices on the cable shows devoted to financial info-tainment, but, despite their loud blather, they do not add up to much more than a whisper of usefulness. You and only you have a full understanding of your risk tolerance and your objectives. Nonetheless, irrespective of your detailed objectives, your probable intent is to earn returns and to stop losing money… so there are a couple things you can do on general principle.
If you need liquidity now, then there really is no dilemma. Sell. If you need cash now, the only thing better than cash is money.
If, however, you own a truly diversified portfolio of investment assets, then those assets probably do not represent “I need it now” money…. in that case, I would advise against it. Don’t sell yet. There are better alternatives.
Volatility premiums in the options market are very high. If you are willing to pay a premium in 31 days, after a liquidation event, then do not wait. You can construct a synthetic call option or put option based upon the current constituents in your portfolio. A call option can be constructed synthetically by being long the cash (stock) and buying (long) a put option. You can buy put options individually for each of the long stock positions in your portfolio or you can simply buy a put option on the broad index such as SPY… Look on finance.yahoo.com for short dated put options on SPY. Buy no more than 60 days out for expiration because you will pay more for the option the further out it expires.
Alternatively, probably what I would do given that the market’s downside is fairly, though not absolutely, defined at Dow 7500, is construct a synthetic put by selling call options against the portfolio. You can sell call options against each of your long stock positions: with volatility at all-time highs, the practice will capture a large premium per position, as much as 10%. This practice is called a synthetic put, or “covered call.” If prices move sideways, it will have brought in a cash return on the portfolio while holding onto the current stock positions. Try to sell the call options at 60 days or more to expiration in order to take in higher premium.
I like the latter because it allows the carefully chosen portfolio to hold onto otherwise strong companies even if the stock prices do not agree. It minimizes the downside while avoiding liquidation or trying to time the market. Clearly, if a portfolio is down substantially, it will take huge returns to get back to even, but blue chip stocks that have taken a beating will be among the first to roar back when the time is nigh.
The first strategy is mildly bullish, the second strategy benefits from short term sideways noise, the likely scenario for months to come.
- Wayne Weddington