Hedging Strategies Through Options By Hussman

I have been contemplating how I can hedge my portfolio with less risk. I decided to take a look at how Hussman mutual fund managers do it. Using from their semi-annual report, I found out that they had the following outstanding option positions:
Effectivley Long: Call on 10000 S&P 500 index option, expiring 2/17/07 at $1420 strike price.

    Effectively Short:

  1. Put on 8000 Russell 2000 index option, expiring 03/17/07 at $780.
  2. Put on 10000 S&P 500 index option, expiring 03/17/07 at $1330.
  3. Put on 6000 S&P 500 index option, expiring 03/17/07 at $1400.
  4. Sold Call on 8000 Russel 2000 index option, expiring 03/17/07 at $700.
  5. Sold Call on 6000 S&P 500 index option, expiring 03/17/07 at $1250.
  6. Sold Call on 10000 S&P 500 index option, expiring 03/17/07 at $1330.

Whether Hussman had gains or losses from these trades, it really depends on how well he timed the market. First, I’m just going to study the hedging strategy these options provide to his portfolio.

His long position basically cancel out short position #2, without regard to the difference in the calendar dates. The rest of positions, only Put can provide full downside protection. Selling calls only allow your downside protection to the strike price. The thing to note here is that at the time when this report is out (12/31/06 I supposed), the price for S&P 500 was at 1418.30, and Russell 2000 was at 787.66. If you take a look at the calls that were sold, all of them were deep in the money. When deep-in-the-money calls are sold, it basically amounts to short-selling with less time premium (but more downside protection to the strike price). The puts that were purchased were mostly at-the-money. With this combination of calls & puts, Hussman is able to provide a downside protection from both of his calls & puts, assuming that S&P 500 stays above 1250/1330, and Russell 2000 stays above 700. The total hedging power assuming that S&P 500 stays above 1330 would be roughly (6000 + 6000 + 10000) * $100 per contract * S&P 500 value + (8000 + 8000) * $100 per contract * Russell 2000 value = 4.38 billion. (S&P 500 and Russell 2000 values are from 12/31/06). Or 2.96 billion if S&P 500 falls below 1330, but stays above 1250. Since the total NAV is 2.84 billion, and total common stock value is $2.89 billion, Hussman had his portfolio fully hedged.

Now if I look at the actual gain/loss from his positions, his effectively long position lost about $5.8 million, and his puts lost about $5.1 million, while his sold calls lost about $8.8 million. If he has not closed out his hedging positions since 12/31/06, his hedging positions would be losing more money by now since overall the market has moved higher. Obviously, his long stock positions are moving higher too to counter the losses from the hedges. But with a total loss of about $19.7 million, he is able to pretty much fully hedge a portfolio value of $2843 million or 2.843 billion. That’s a loss of about 0.7% (on 12/31/06).

Such hedging strategies definitely provide a very good protection when the market falls. However, because of the hedging, Hussman strategic growth fund has been underperforming the general market in the last 2 to 3 years. Such is the cost of being a market timer when the market does not cooperate with your actions.

In the next post “The price of a free(?) hedge”, I will look at my own hedging strategies using stock options of calls & puts in a similar fashion that Hussman has done. It’s certainly much easier to study what others do than putting everything in action. One can be so grandiose about the term hedging, but after all, what it really means is selling out in a certain way. Whether this “certain way” is smart or not, the performance will speak for itself.

P.S. By the way, the pricing/cost between options on futures market and options on stock market is similar (or else someone can arbitrate between the two). The only difference in cost may be simply the brokerage commissions.

A Dash Of Pink For Your Portfolio

Random Roger wrote about the Vietnam opportunity fund last week. Vietnam was in the news recently because of the failed trade bill on the eve of the APEC summit. In spite of that, Vietnam is due to become the newest member of the WTO next year while it’s doing to China what China has done to others in manufacturing. Roger’s article was about how much emerging markets in general and the Vietnam fund in particular has appreciated in the last couple of months, but I mentioned it as a long segue to the topic at hand which has to do with pink sheets.

It turns out the Vietnam Opportunity fund (VOF.L) trades in London which makes it difficult to buy from an online broker with the exception of IB. Fortunately, it’s accessible in the over-the-counter market known as the pink sheets. It trades under the symbol VTOPF at a decent volume of 300-400k shares/day. Most online brokerages (TD Ameritrade and Scottrade for sure) treat pink sheets exactly the same as other stocks/ETFs.

Pink sheets are formally defined as

A daily publication compiled by the National Quotation Bureau with bid and ask prices of over-the-counter stocks, including the market makers who trade them. Unlike companies on a stock exchange, companies quoted on the pink sheets system do not need to meet minimum requirements or file with the SEC. Pink sheets also refers to OTC trading.

The name came from the pink paper they are printed on. They have a bad rap as a lightly regulated market where penny stock pump-and-dumpers cruise for their prey. That reputation may be deserved; however, some well established foreign companies can also be found there. They tend to be smaller than household names like Sony and Nokia that have ADRs, but are solid nonetheless. In addition, a large number of Canadian junior mining companies can also be bought via pink sheets. While riskier, they aren’t exactly fly-by-night operations either.

Below are some examples that I have looked at one time or another. This is not a recommendation for purchasing them.

Established foreign companies
Sherritt S.TO/SHERF.PK (Large Canadian company in coal, oil and base metals)
Canadian oil sands trust COS-UN.TO/COSWF.PK
Western oil sands WTO.TO/WOTIF.PK
Vestas wind systems VWS.L/VYSPF.PK (Dutch wind energy company, trades on just about every European stock exchange)

More speculative plays
International Uranium IUC.TO/IUCPF.PK (uranium mining and processing)
Denison Mines DEN.TO/DNMIF.PK (uranium mining)
Dragon Oil DGO.L/DRAGF.PK (Caspian oil)

Symbol look up
Normally what happens is that you have a foreign company that you are interested in, but it’s only listed on a foreign stock exchange. You can use the Yahoo finance symbol look-up to see if it trades as pink sheets. Note you have to specify US&Canada or World Markets in the pull-down menu. After locating the symbol, you can check with your broker to see if you can purchase it from them. Yahoo uses the “.pk” extension, but most other quoting services do not.

Intraday quotes/pricing
The pink sheets are quoted only at the daily closing price. For intraday quotes you have to use the symbol on the native exchanges. Note the quote will be in the local currency while the pink sheets trade in US dollars, so you will have to do a conversion when placing an order.

Caveat emptor
– Limit orders are absolutely necessary as the volumes are usually low.

Places to do research
Canadian Stocks: Stock House
London Stock Exchange

As always, you need to thoroughly research what you’re getting into. But for those daring, a dash of pink may do wonders for their returns.

Portfolio Update: Bought Some Mutual Funds

I used some 20% of the cash in my 401K to buy some mutual funds, mostly large cap stocks (both value and growth).

S&P 500 is right at the resistance of 1290 – 1295, but I’m just going to get into this market first with plenty of cash left if it pulls back.

My networth page won’t be updated until tomorrow.

Good luck trading.