Saturday, January 10, 2009

BARRON'S ROUNDTABLE/Hedging Successes and Failures in 2008

After reading two pages of the annual Barron's Roundtable, the usual doom and gloom pervaded by my conscious being and I was just about ready to throw myself in a cauldron of boiling oil rather than face 2009. I am sure that there are people who buy the recommendations made by the panelists-but why exactly? It is just not the dismal records for last year. It is hard to find a worthy portfolio of picks any year that I can remember. This Felix Zulauf fellow has to be the long lost conjoined twin of Alan Abelson. After being separated at birth, Abelson became the more optimistic one.  Faber takes great pride in saying that he had just bought a U.S. stock for the first time in 30 years. Is that smart?  

Abelson was at least a bull on the U.S. market for a couple of months in 1982. I generally find this kind of perennial pessimism to be as useless as most of the panelists' picks. I would be curious if I invested a million in their picks starting five years ago, equally dividing the money between them, how I would have done during the past five years? Would I have any money left? I do value the opinion of Bill Gross and Hickey's opinion about tech company valuations since I am not much of a tech investor anyway. I would agree with his opinion on Microsoft which I just bought back a week or so ago. Microsoft Buy/ISIS sold in IRA/ AEGON PREFERRED STOCKS I suppose someone could keep recommending Kaiser Aluminum and be right one year about it. 

Another one of the recommendations, Discover Financial Service (DFS), is on  one my monitor lists and DFS was on it when it was at 16.  I did not buy it at 16 and I am not buying it at 9. The credit card companies are very likely to have several bad quarters coming, and the market does not appear to me to be in a forgiving mood. While it is not news to anyone that there will be credit losses, it may be news on the amount of losses in the months to come. The favorable points made about DFS are also well known.  What is not known, and is ultimately not knowable now, is how bad the credit losses will be in 2009.  

I was asked whether SDS buys from last two years were bets, investments or hedges. I viewed them at the time to be hedges. I was out of all the double shorts by the time of the Lehman bankruptcy, for reasons previously explained, which will cause a change in my approach for using SDS in the next unstable VIX pattern forming out of a bull pattern. While I will do some selling based on the movement of the VIX to the mid 30s and buying below 20 during the unstable VIX pattern, I intend to keep at a minimum 100 shares of SDS throughout the unstable pattern until the formation of a new VIX bull pattern. I was doing fine with the hedges until I took them off before September 2008 which turned out to be a mistake. 

The swing trade that I previously described was a timing mechanism to put on and take off the SDS hedge.  It was working find until I failed to buy it back on August 22, 2008 when the VIX fell to 18.81. I wanted another point, which would generally be associated with a down move in SDS and an up day for the S & P, similar to the opportunity given on May 15th when the VIX fell to 16.47.  I was waiting for a 16 to 18 range which I did not get so I was out of SDS at the time of the Lehman bankruptcy. But, based on what I was doing at the time, I would have sold it again in late September after a spike into the mid to high 30s for sure, possibly even before it hit 30 since my discipline started to break down on holding SDS even before the Lehman bankruptcy.  

I had bought in August and sold again in late September, doing neither, I would not have been given another chance to buy it again using my then existing model, since the VIX has not fallen of course anywhere near 16 to 20. The events in September caused me to change for the future what I had done in 2008 which had actually been positive until that point. It would be okay for me to sell some SDS on that spike into the 30s but I need to keep some as a hedge. I was not using TWM in 2008 to hedge small caps because I jettisoned them in 2007 except for the RVT and RMT closed end funds. I was using TWM in 2007 to hedge my small cap positions I found that the TWM hedge produced more profits as a hedge so I may use it in conjunction with SDS again as a way to hedge a stock portfolio even when I have insignificant small cap exposure which is the case now as it was throughout 2008.   

I started to use the double short ETFs in 2007 as a hedge because I started to become very nervous about the mortgage mess in May 2007, so much so that I had already started to research the new products that Proshares had started to offer. I wanted to experiment with the double short ETFs as hedges.  It was in May 2007 that I made my first buy of 30 SDS shares. I do not think that I had the VIX model then and was just doing the earlier trades by the seat of my pants.  I develop a rough VIX model by mid summer or thereabouts since I had no framework for what I was attempting to do then and started to look for something that I could use as a guide.   

I tried trading it in small amounts at first, to see if it worked, and  I did seven buys and sells, 30 to 50 shares at a time, and netted a profit on each of them, never owing much at one time, with a grand total profit for 2007 on SDS of $728.86. I did three smaller buys of TWM, two of them a mere 25 shares, profited on each of them, for a total profit of $544.63. I was experimenting so I tried QID and made two out of two profitable trades and MZZ, making 2 out of 3 profitable trades. So I just reached a comfort level doing this hedging when I started to become nervous about the developing credit fiasco.  

The VIX model itself was a development in progress in 2007. Contrary to what you read and hear from the Robert Rubins of the world now, any reader of the news would have started to have concerns no later than February 2007 about the developing mortgage crisis. (just enter in google February 2007 subprime). I did not view  any of those trades as a bet or an investment, but as a hedge that I was putting on and taking off. As a result of this experiment, which also included SKF bought in November, I decided in 2008 to limit most of my new buys to SDS  which was working until I took  it off way prematurely in my main account on a spike to close to 30 in the VIX in mid July 2008, although I may have kept a smaller position in an IRA for longer including a small TWM and maybe MZZ holdings.   

In retrospect, part of my problem was that I wanted to make money on the hedges which is what I was doing rather than looking at them exclusively as hedges and only secondarily as potential money making opportunities. I started looking at them as money making opportunities because I was making money on them, simply put, trying to time the purchases and sales.  This is okay as long as I continue to refine what I am doing with them but, as I said, I need to keep some in place for the duration of the unstable volatility patterns.   

So I will try to make money on the hedges for my bond portfolio. Assuming I ever reach a maximum hedge of 200 TBT, then I can trade that down to 100, back and forth, but I have learned  at least one lesson in 2008 about trying to be too cute with these hedges. I simply have to recognize that having the hedge is worthwhile as insurance even if I lose some money on it eventually. I simply have to convince myself that it would even be okay to lose on the hedge if I was concerned enough to buy in the first place.

But since I do not like to lose money, even on hedges, I ended up not having them in place when I needed them the most and that was the main lesson from 2008.  So many of my decisions on the hedges in 2007 and 2008 were good and some mistakes were made, which did not result in a loss on the hedges, but a failure to fully exploit the double short ETFs as insurance hedges for the duration of this bear market.  

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