Why I Don't Hedge

Oh, man. You KNOW I have to take THAT bait! OSIP is a situation I wouldn't have hedged...so I would have bled a deep red on that one too. Hedging is cool under special circumstances where you are feeling a big move coming but you don't know which direction. Or perhaps you are biased towards a certain direction, but want to try to come out even if you are wrong. Say, a Bollinger squeeze (where volatility has been low for quite some time), or when there is pending big news, but the market could go either way (like with PLMO's earnings last night - did anyone even notice that PLMO's guidance for the year remains the same?!?). I know your quote came from me, and certainly, the worst hedges have been when I was right, but had the complete wrong timing. A certain MSO comes to mind....ugh!

Thanks for the elucidation. Yes, I've heard that from you but you're not the only one.

I should have added what I *might* have done is bought puts instead of shorting since bio-wrex are so unpredictable. But in this case, I sure would not have been savvy enough with the (potential) news to feel like the premiums (and risk) on the options would have been worth it. Your experience here though has been duly noted.

I might have to swear off of the sector(s)

Hedging...a great way to lock in losses and limit profits.
I've always lumped hedging in with "portfolio diversification", at least in the way the "financial planners" like to sell it...just nice words for saying you're either risk averse or too lazy to do the work.
Now, I'm not saying that you can't have on two diametrically opposing positions with their own valid reasons, such as long CSCO and short the QQQ(Q)'s (not that I'm either); which some might consider hedging. But each position is on and managed for it's own merits.
But risk management is the only proper loss limit tool if you're serious about the biz...IMHO.

If you are trying to make money on the short term moves of a stock (not something I try to do BTW), I think you are correct. Hedging makes no sense. If you want to limit your downside, take a smaller position.

Hedging only makes some (limited amount IMHO) sense if you are trying to achieve a market neutral position.

I think hedging for the short-term is one of the best places to use the technique. I will create a stylized example...Say, you think that there is a 40% chance that some pending news will be good AND the market will react accordingly. But there is a 20% chance that the peding news could be awful and the market will also react accordingly. In between, the market might do nothing. Now, you could choose to leave this thing alone...which is a valid choice for managing risk, particularly when you cannot know the outcome. Or, you could discover that the options for this stock are mis-priced according to your expectations, and there is substantial upside potential if you are correct. If this is the case, you can set up a position that matches your expectations but also caps your total potential loss if you are flat wrong. You can also set-up the position any way you like....so, you can have positions that have unlimited upside and small downside if you are extremely aggressive. You can also set up positions such that both potential losses and profits are very limited (in which case I think most folks simply wouldn't even bother - which is usually the correct thing to do!). If you *really* dig into this, you can see that ANY stock position WITH stop losses can be simulated with hedging (options). A very blunt mapping is to only apply the amount you are willing to lose on the stop to the total of the hedged position. The one EXTRA feature you get is that you KNOW you cannot lose more than your planned stop. With a stock trade, you can easily lose more than your planned stop if the market blows right through it overnight or intra-day. The big minus with hedging is the amount you pay in commissions and spreads.
If you are trying to follow a trend, you could even set up a hedge that allows you to sit tight through any whipsaws that ensue before the trend really establishes itself. You pay up-front for the protection of course, but it could end up being cheaper than getting in and out over and over until the market finally agrees with your assessment (or until you figure out better stop levels for the volatility you are dealing with). I have never tried this one, but I am sure some brain out there could figure this out if it hasn't been already.
Finally, I would say that I am definitely not advocating hedging as a prime strategy. I am saying that it can be quite appropriate under special circumstances, especially in the short-term. For example, I think hedging is a waste for long-term bets, like for your IRA.

I think this link to Todd Harrison gives a good idea when to hedge. The ideal situation, according to his set up, is when the market underestimates the volatility and you've picked a direction.

http://www.thestreet.com/_rms/comment/harrison/1033498.html

I gave up shorting after too many situations like OSIP. Shorting is like trying to push a ball underwater.

In "Less Is More", Roger gives an EXCELLENT example (using a deep in-the-money call on NTAP) of a situation where buying options makes a lot of sense. It is not hedging per se, but it actually can represent *less* risk than owning the stock outright.

Mike: Tuff break on the osip. I feel your pain brother. Nobody deserves to have a stock gap up 20 points when their short...............wow. I'm still shaking my head on that one. I would of done a triple axle out of my window after seeing that!

I don't know many people that use hedges in general except in market neutral funds. Hedges are a good call with a difficult-to-forsee event like OSIP - anything event driven. The only other time I use a general hedge is if I think, as now, that the market may be overbought (or oversold) and I want to hedge the whole portfolio for some overall insurance.

Not trying to rub salt in your wounds Mike, but the better way to play OSIP, imho, was to play the straddle if you are comfortable with options(I wish I had but only noticed it after the fact). When you can't pick a direction - play the volatility. You could have bought some out of the money calls and puts for $2 the day ($1 for the call, $1 for the put). It helped that the announcement came on expiration day (hence no time premium). The call option jumped to $11, the put expired worthless. Incredible ROI for very small capital investment. This technique works very well for biotech where the moves are strong and extreme, but in fairness the OSIP was a bit of a special case - I was shocked that the straddle could be bought for that little. Comments welcome.

i dont hedge. i accept risk when i enter a trade, but i think long and hard about the level to which i want to be exposed (i know you did that on the osip trade mike, but that sector is madness). i guess my expample of when of when its time to hedge is when you have way too much exposure. mark cuban ring a bell? through his deal with yahoo, he ended up with truckloads of stock. i think with a situation like his, not hedging is not an option. i'm down with what duru is sayin, in those situations, i'm waitin till i get a better read, or play it like DJ with a smaller size.

Chad, good point. When you are overweighted in a particular segment of the market, like a huge grant of stock options, you have to hedge if you can't or don't want to sell down some of your exposure.
As far as OSIP, let's not forget that Mike wasn't playing or anticipating any news. It was a simple technical pattern that had short written all over it. Only someone closely following the bio-tech news would have even guessed that a rival company might have a material announcement coming right around the corner.

Just from observation, I do better overall when I hedge.

I do trade volatility a lot, with long calls, short stock (positions in CMCSA, UNTD, TWX, AT)

I don't hedge the small cap biotechs that I use like option buys.

Anytime I'm short (except an index), I do so with options, option spreads, or directional butterflies. Why? I'm so afraid of takeovers, manipulation, or stuff like MSO recently (no position).

Take FNM for example. I've heard that 4 mutual funds own about 40 percent of the shares. They aren't just going to dump and take the loss. Whatever the stock is worth (less than current price), they could still pull some shenanigans and inflict some short term pain that most 'pure shorts' can't stomach (I'm short via directional butterflies).

With volatility so low, the price is right to hedge, and at least as of now, I use the investing to supplement my income, not as my income.

ron, with vol so low i wished i was playin that way. from the way you describe it you essentially set your stop(for your short) at your strike price you purchased your calls? or am i way off?

p.s. sorry bout that duru, i totally see how mike was tradin that from a pure technical play. my comment was just about how fickle/unforgiving/shocking&insane that sector moves.

hi mike,
what's your take on "elliot wave priciple"? Thanks in advance.

SK,

I have a copy of that book but I haven't read it yet. Nor have I read anything else about Elliot Wave.

There have been many times I could have made a lot of money instead of break even or make a much smaller profit if I did not hedge. But then there are those situations where I'm glad I was hedged. It's like insurance, you ask yourself why you're paying that premium but you're glad you did when something goes wrong.

Also it depends how you do it. I did very well longing PALM (NASDAQ: PLMO) and shorting RIM (NASDAQ: RIMM). My thesis was that from the expected earnings and revenues, PLMO's and RIMM's P/Es were out of line and either PLMO was undervalued or RIMM was overvalued. This trade is mainly an arbitrage trade, but by going long-short, I was also hedging downside risk in the market and the tech sector.

Of course, if your just hedging a stock with a put option, its reducing your downisde but also your upside. It all depends on what kind of risk you are hedging out.

I welcome you to check out my tech stocks blog at http://brianshiau.blogspot.com