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Hedging Your Portfolio
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KiLrOy
Master |
26-Oct-2007 16:20
Yells: "I buy only what I can see." |
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Here's one for the last day of the week before I head to the floating casino for the weekend again. You may have already read this on shareinvestor.com but here's an extract from kleer of http://extraordinaryprofits.blogspot.com/ and my guess is that some folks here do use this strategy on serveral occasions as well. Personally I don't as I am a firm believer of DCA for SG Stocks. But today, I read another strategy of using warrants to hedge your portfolio. This method is used by one of the investors I respect a lot - Dr. Michael Leong aka Oldman from shareinvestor. I will be summarising his posts so as to avoid copying them word-for-word. Many people always ask when is a good time to purchase put warrants for hedging purposes, and I think this approach answers the question very well. This is Oldman's strategy: 1) He does not hedge against a correction, only against a collapse.
For example, though he felt strongly in August that it was only a correction, when the STI index fell more than 10%, he started buying put warrants, just in case his gut feel was wrong and it was a start of a collapse. Fortunately, it was not and when he felt that the upturn was round the corner, he sold most of his puts at multiples of what he bought them for. His profit from those warrants more than covered the fall in the share prices of his fundamental stocks. 2) One of the put warrants he have bought during the August correction was the DBS BNP ePW070910 which he purchased then for 0.5cts. The warrant expires on the 10th September, the exercise price was $18.96, and DBS then was trading at $22. This means that if DBS does not go below $18.96 within a month, the warrant will expire worthless. The rationale behind the purchase of this warrant is that DBS is unlikely to fall below $18.96 unless the entire market crashes. As such, he purchased the warrant to hedge against a market crash and not a market correction - which is to say that he was willing to write off the total cost of the warrant in the event that the market crash does not occur. In fact, he also states that he would prefer that it is only a correction and for the warrant to expire worthless. In that case, what he paid for the warrant can only be a tiny fraction of his net worth. How to employ the hedging strategy according to Oldman: If your portfolio is worth $100,000 and you are a long term fundamental investor who believes that the market is still bullish but the market may be going through a correction, you may want to protect your investments by buying some put warrants which are deeply out of the money. This means that you will not make money from these warrants unless the market really crashes significantly. In the event that the crash does not occur, you should be happy and willing to write your cost of the warrants completely. Think of it as buying term insurance for your stock portfolio, just like buying a travel insurance policy which is valid for a limited time only. This insurance is bought in case the reading is wrong and instead of a correction, it is a major megatrend change to a bear. You would then buy put warrants that translates into $100,000 worth of mother shares. Which put warrant to buy, unfortunately, is more an art than an absolute certainty. But for this current situation in August, Oldman rationalised that since the cause of the market selldown was the subprime issue, naturally, it would be the banking stocks which would be under pressure. Hence, during the last correction, he bought put warrants in the bank stocks, and also bought put warrants in property stocks with residential exposure as he felt that if there would b e a downturn, such property stocks may feel the pinch more. In short, one has to make an educated guess as to which sector will be most affected in a downturn. Oldman's Conclusion: Investing is about taking risks and managing risks. This is how he manages the risk of a market crash. He can only afford to do this once a while as buying insurance via put warrants is never cheap. But when the risks are high, he reckons that it is worth paying for these put warrants as they give him peace of mind in the event that read the market wrongly. |
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