New Strategy using Buy & Hedge approach

by Wayne Ferbert on October 25th, 2012

For me, the hardest part about investing is capital allocation. It is deciding how much money to deploy between two investment opportunities I like. When making the decision, I also weigh the factors around how that choice would affect the rest of my portfolio risk profile.
 
There are lots of models available to me to help to make these decisions – but these models are based on historical risk & return events. While history repeats itself a lot in financial services, the actual risk/return results do not always follow the model.
 
So, investing always comes back to the decision about allocating capital. I always set aside about 1/3rd of my portfolio for my ‘inner guru’ picks. These are the picks that you use your own investing intuition to make investment choices.
 
I read a lot of research – but the investing research I align with the most is Morningstar. I prefer their research because they mostly follow a value investor approach (like me!) and the other businesses they are in do not create a conflict of interest with their research.
 
Morningstar’s research system for stocks and ETFs is straight-forward. They use a 1- to 5-star rating system and they provide a fair value estimate for all of the stocks and ETFs that they cover. They also provide guidelines for the prices for entry and exit.
 
So, for my inner guru picks, I am going to start using their rating system and entering in to OTM bull put spreads for their best 5-star picks – and OTM bear call spreads for their best 1-star picks.
 
If I get triggered in to owning the stock on from the short put – so be it. It means I got a bargain on a highly rated stock. And, my hedge is already in place since I own the put. The same is true for the short calls. If I end up short against an over-valued stock, at least I own the protection level already with the further OTM call.
 
This portfolio will deploy some modest implied leverage – about 2 to 1. This is mostly because the call side will be close to the value of the stock controlled on the put side. More than likely, in a correlated market move, one side would win and the other would lose. This is why I can get comfortable with the implied leverage greater than 1.0x. Hopefully, market correlation continues to decline and we can win on both sides.
 
Right out of the gate, I have already deployed this strategy on the Bullish side against FB, MSFT, BLK, CAT, and SCHW. It already paid off nicely on FB. We’ll see how it does as we deploy it against the bearish picks and report back to you!



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1 Comments

Don S - October 26th, 2012 at 11:10 AM
I follow you on twitter, will you be updating there on how this strategy is working? i think this is a great idea and am curious how this goes.

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