What's a hedge?
What's a hedge?
May 10, 2001
Many of you have written asking for an explanation of the hedging strategy I discussed yesterday. A quick outline is in order.
Hedges come in a variety of shapes and sizes; True hedge funds (not the merely aggressive short term trading funds which have popped up in recent years) are market neutral -- their long positions more or less balance their shorts; Their stock selection is based on their shorts going down more than the longs in a sell off, and their longs going up more than their shorts in a rally.
Since shorting involves borrowing stock you do not own (and buying them back later), it is technically considered a margin transaction -- even if it is done with cash.
I put on a basket of stocks as our hedge; The stocks were each selected for a variety of technical reasons:
-Micromuse (MUSE) had broken both below its support and its crucial 50 day moving average on heavy volume. Thate is a classic technical sell signal and was our strongest short candidate;
-Seibel Systems (SEBL) had seen its money flow dry up. That's an estimate of how much new cash is coming into an equity, and often precedes a pullback;
-Mercury Interactive (MERQ) was trading way above its moving average -- a sign of "too far too fast."
We could have closed the latter too positions on Monday (before the Fed meeting) for a larger profit. But this was not a trade for a trade's sake -- this was a specific strategy to protect the long positions we owned.
For each million dollars in an account, we put on an approximately $150,000 hedge -- thats a 1000 shares of each stock.
We said there was a built in expectation of the Fed cutting half a point, and so there was not much hope of a Fed cutting rally; Had the Fed "only" cut 1/4 point, or cut a half point but shifted their bias to neutral, there would have been a bit of panic -- and a 100 - 200 point sell off.
The idea was that these high beta, tech Nasdaq shorts would have gained nearly as much value as our diversified longs would have lost.
Instead, the Fed made a very bullish pronouncement -- 1/2 a point, and yes, more on the way. SEBL, which had a very strong upgrade that morning, was for a small loss (point and half). We covered MERQ for a small gain (point), and kept the MUSE short on. As of yesterday's close, that short was 4 - 5 points, or about 12%, in the money.
Normally, "insurance" costs you money in premiums but protects your holdings (car, house, jewelry) against loss. Good stock selection -- and a bit of good fortune -- allowed us to not only have a strong hedge against a potential Fed-induced disaster, but also to make a few sheckels on the transaction.
The additional long term hedges via leaps (year long options) in IBM and Krispy Kreme are still under consideration. These are stock specific, and are still being researched.
Our thesis still remains intact -- after the run up. A pullback to the 1950 to 2050 levels. We will be making specific buys as we approach those levels, and finding the appropriate levels to cover our remaining shorts.
Please feel free to write or call if you have any additional questions . . .
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