Q. In looking at Bill’s brokerage statements, I notice that he not only uses a lot of margin, but also that he owns significant options positions. Isn’t this incredibly risky?
A. While we acknowledge that his investing style isn’t appropriate for everyone, it’s actually not as risky as it seems. In general, he tries to maintain a 100% exposure to stocks. He often does this by using, for instance, $400,000 in account equity to buy $600,000 worth of stock – and then buying put options that are likely to gain whatever might be lost on the $200,000 in stocks bought with borrowed money.
Though risk is certainly introduced because he tends to buy puts on SPY (the S&P 500 ETF) while investing primarily in nano-, micro-, and small cap value stocks, these stocks’ returns are typically highly correlated with those of SPY in the event of dramatic market downturns.
Despite microcaps and small cap value stocks having long histories of outperforming the S&P 500, there is no guarantee that they will do so in any particular month. As we have mentioned elsewhere, past performance does not guarantee future performance.
Managing risk is especially important to anyone who tends to take large risks, whether one’s enthusiasms run to hang gliding or investing. Bill takes the following steps in his attempts to avoid ruin:
- He diversifies broadly, usually owning between 50 and 100 different stocks in a variety of industries.
- He sells aggressively when companies report disappointing news.
- He focuses on profitable companies with relatively low ratios of price to sales, earnings, and tangible book value.
- He employs a dynamic hedging strategy, using put options.
Q. How does Bill’s dynamic hedging strategy work?
A. Let’s say that his margin debt balance is $200,000 and that he owns 20 March 200 puts on SPY (the S&P 500 ETF), which is currently trading at about $210 per share. What does he need to do in order to fully hedge against SPY declining?
The critical piece of information needed to solve this problem is the delta of the puts. The delta is the amount by which a put’s price is expected to move if the underlying security moves $1. We’ll assume that the delta of this particular put is .33. (Delta figures are provided online by several major brokerage firms, including TD Ameritrade.)
If the price of the put is $5.50, $11,000 of the borrowed $200,000 is being used to finance put holdings, rather than stocks. This leaves us with a need to hedge $189,000 worth of stock.
The current holding of 20 puts can hedge $138,600, calculated as follows:
20 puts x 100 shares per put x .33 delta x $210 SPY price = $138,600
Therefore, he would need to buy more puts in order to cover the $50,400 difference.
Each put is capable of hedging $6930, calculated as follows:
100 shares per put x .33 delta x $210 SPY price = $6930
Dividing the $50,400 hedging need by $6930, gives us 7.27, indicating that buying 7 puts would (at that moment) result in the most accurate hedge of a SPY position worth $189,000.
Were SPY to suddenly fall to 200, the delta would rise to approximately .5. Intuitively, this makes sense if we believe that SPY has a 50/50 chance of falling further between now and the put’s expiration (thereby enabling the option to have value at expiration). If an option has a 100% chance of expiring in the money, it will have a delta of 1 because its holder will profit or lose money dollar for dollar as the underlying security’s price moves. But if the put has no chance of expiring in the money, the underlying security’s price movements will have no effect on the holder’s gains or losses, and its delta will be 0.
Given a delta of .5, the updated position of 27 puts would hedge $283,500, calculated as follows:
27 puts x 100 shares per put x .5 delta x $200 SPY price = $270,000
We now have a $203,850 margin loan because we spent $3850 to buy 7 puts at $5.50.
If the price of the put is now $10, $27,000 of the $203,850 loan is being used to finance put holdings, rather than stocks. This leaves us with a need to hedge $176,850 worth of stock.
Again, the current holding of 27 puts can hedge $270,000. Therefore, he would need to sell more puts in order to eliminate the $93,150 difference.
Each put is capable of hedging $10,000 in SPY, calculated as follows:
100 shares per put x .5 delta x $200 SPY price = $10,000
Dividing the $93,150 excess hedge by $10,000, gives us 9.3, indicating that selling 9 puts and keeping 18 would result in the most accurate hedge of a SPY position worth $176,850.