Pestrichelli and Ferbert, Buy and Hedge

Long-term investors are faced with a host of difficulties. As a strategy, “buy and hold” has been a dud over the last decade. Diversification sometimes helps, but when it’s most needed it usually doesn’t. Jay Pestrichelli and Wayne Ferbert offer an add-on in Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term (FT Press, 2012). As the title indicates, they suggest that investors use options to hedge their stock positions.

The basic premise is both simple and sound. Risk is the input to your portfolio, return is the output. This means that you can control risk, not return. Put another way, risk is what you buy, return is what you hope for.

The authors hammer this point home over and over, and they’re wise to do so since investors invariably focus on the potential reward of their position, not on the actual risk they are incurring. Yet they might just as easily be pinning their hopes on Enron as on Apple. Stock picking is tough.

And so, the authors argue, the solution is to define risk. Ideally, every investment should be hedged. Alternatively, the portfolio as a whole can be hedged. The authors outline a range of strategies, from married puts, collars, and ITM options to vertical and diagonal spreads, to accomplish this goal.

Since for the most part the authors view options as hedging vehicles, not speculative instruments, the focus is on risk management. They boil risk management down to four metrics, all of which should be used in analyzing a portfolio: capital at risk, volatility, implied leverage, and correlation.

Implied leverage may be an unfamiliar concept, so let me describe it briefly. First, what it is not: it is not using margin to buy stock. Rather, it focuses on the power of options to create leverage for a portfolio. That is, if an investor uses options to create exposure to equities and ETFS, he likely uses less capital than if he had bought or shorted the equity or ETF directly.

The authors offer the following example. “Suppose an S&P 500 ETF is trading at exactly $100 per share. You open an account with $100,000 in cash. Then you purchase ten Options contracts that are calls with a $90 strike price that expire six months from today…. The price of these Options is $11 per share…. Since a contract has 100 shares, the total price is $11,000. And with these ten contracts, you control 1,000 shares….” (pp. 81-82) The $100,000 portfolio is comprised of $11,000 in the SPY call options and $89,000 in cash. The implied leverage in this case is 1.0, calculated by using the formula (total market value of nonderivative securities + implied equity value for each derivatives position) / (total portfolio value – borrowed money).

If you add 2,000 shares of MSFT trading at $25 a share, your $100,000 portfolio now has an implied leverage of 1.5 because it controls the $100,000 of implied equity value plus $50,000 worth of MSFT. The numerator is now $150,000, and the denominator doesn’t change. The portfolio with the higher implied leverage gains more in an up market and loses more in a down market. If, for instance, SPY and MSFT both increase by 10%, the first portfolio will be worth about $109,750 and the second portfolio $114,750. If they both decrease by 10%, the first portfolio will be worth $91,000 and the second $86,000.

The authors conclude that “too much leverage increases your portfolio’s volatility by increasing the portfolio’s rate of change. The recommendation from Buy and Hedge is to avoid all excess leverage. Your implied leverage should always be 1.0 or lower. Your traditional leverage should always be 1.0 also.” (p. 85) Advanced investors who are looking for specific risk trades will end up with implied leverage well past 1.0, but the authors are trying to steer investors away from taking on speculative options risk. They are first and foremost hedgers.

Throughout the book the authors offer advice for long-term investors. For example, in the chapter “Harvest Your Gains and Losses” they identify when to reset your hedge in an investment that has an unrealized gain. Their suggestion is that once the unrealized gain of an investment is at least 50% of the total capital at risk for that investment, you should consider resetting the hedge to lock in gains.

Buy and Hedge is an eminently practical book for the long-term investor—and there are mighty few such books around these days.