Hedging
This is the third in a series of MBA Mondays posts about risk and return. Last week we talked about diversification, my favorite form of risk mitigation. This week we are going to talk about another favorite risk mitigation method of mine – hedging.
There are different types of investors in any highly developed and liquid market. There are speculators who are looking to make risky bets and you can use them to reduce your risk by taking the opposite side of those bets. Doing this is called hedging.
Let's go through some real world examples. The simplest one is shorting a stock that you own. Let's say you own 1,000 shares of Apple that you bought during the 2008 market break at $75/share. The Apple shares are now at $267/share and you are worried that the iPhone 4 reception problems are going to hurt the stock in the short term. You could sell the stock, but you really don't want to. So you can short 1,000 shares of Apple for as long as you are nervous.
The way shorting a stock works is someone who also owns the stock loans you the shares and you sell them. You promise to give them back the stock at some future date. You pocket the $267,000 you get from selling the Apple stock but you have a liability which is you have to give the stock back to the person or institution who loaned it to you. Fortunately, you still own the stock you originally purchased so you can always pay back the loan in the stock you own. If the stock goes down, you can use some of the $267,000 you got in the sale of stock to buy back the Apple stock at a lower price and use that to repay the loan. If the stock goes up, you are losing money on your short, but making exactly the same amount on the stock you originally bought.
In this scenario, you have hedged your risk of the stock going down, but you are also not going to make any money if the stock goes up. It is like you sold the stock except that you still have your original stock in your possession. You are perfectly hedged except for counterparty risk, which are risks brought on by the other party to your hedging transaction. In this case, counterparty risk is pretty low.
Another form of hedging involves options. There are two primary forms of options, puts and calls. A put option gives you the option of "putting" your stock to someone else at a specific price. A call option gives you the option of "calling" a stock from someone else at a specific price.
Let's continue this example of Apple stock at $267/share. Instead of shorting the stock you can use options to hedge your position. The simplest form of a hedge is to buy a put to protect your downside. Let's say you want to make sure you get $250/share for your Apple stock no matter what. You can buy a put that allows you to "put" your Apple stock for $250/share until August 10th (a little more than 5 weeks) for $27. If that happens, you actually are getting $223/share because you'll get $250/share but you had to pay $27 for the call. That is the purest form of downside protection. It is expensive, but you get to keep all of the upside on the stock. And there is counterparty risk because if the person selling you the put goes out of business, they won't be there to honor the call.
If you are willing to give up some upside, then a better approach is the "collar". In this trade you buy a put and sell a call. The August 10th Apple put at $250 is trading at $27 right now. To finance that cost, you can sell an Aug 10th Apple $280 call for $24. You are still out $3/share but it is must less expensive insurance. However, if the stock goes up to $280, it can get called from you.
I got all these option prices from the CBOE's website. These are the current prices as of Monday morning before the markets open. These prices will move around a lot, reflecting both the price of Apple stock, the remaining time until expiration of the option, and the volatility of the stock.
If you think about the collar, it is a lot like shorting a stock you already own. You are protected if the stock goes down but you aren't going to make much if the stock goes up.
When our venture capital firm finds itself with a lot of public stock that we cannot sell for one or more reasons and we want to protect ourself from downside risk, we like to use a collar. You can use traded options, like the ones I am quoting from the CBOE. Or you can get a trading desk at a major brokerage firm to create synthetic options for you. No matter what you do with collars, it is going to cost something. You are purchasing insurance and insurance has a cost.
It is important to remember the counterparty risk when you are hedging. No hedge is any good if the other party to the transaction is not there to settle up. It is like buying insurance. You want to buy insurance from a highly rated carrier and you want to do hedging transactions with financially secure and stable counterparties. What constitutes that these days is another issue.
In summary, when you have a large gain on your hands, think about taking some of that gain off the table by selling it and diversifying. If you can't do that for one reason or another (taxes is a common one), think about a hedging transaction.
Comments (Archived):
This has always been a funny loophole in insider trading. Typically if an insider or affiliate (or someone with 144 stock) sells stock they have to file a form 4 to disclose the change in the position. But if they collar the stock, no disclosure is required (since no stock has been sold). There are many public companies out there where it looks like management and the top investors are fully committed to their stock but they have actually collared. So additional benefits of collaring include:A) no public disclosureB) no taxes (you only have to pay taxes if the collar is within 15% of the price of the stock when you collar). C) you can typically borrow up to 85% of the lower end of the collar at a fairly low interest rate (since the loan is completely backed by an asset).However, companies are somewhat on to all these tricks so when a VC exits a position the contract usually states you cannot “hypothecate” the position. Meaning, no collars. But this is often waived for the more passive investors.My feeling is that the rules should change a bit to require form 4 disclosure on a collar if the party involved is an affiliate.
i agree jamestotal coincidence – i just left you a reply on your TSCM comment on thestock buyback threada good debate
I just caught part of JLMs rationale on “his blog” http://Disqus.com/JLMBuying outstanding shares to exchange shares without dilution while avoiding the taxes associated with cash.I’ll have to review that comment section while I have a few minutes.
Speaking of the TSCM thread, I had another thought about your idea for using a company’s cash as a sort of internal venture fund. For most retail investors, it would give them some exposure to an asset class they wouldn’t have much access to otherwise. So that’s another argument in favor of it (if it is done right, e.g., when such potential acquisitions are available at good prices).
One additional comment. You usually can’t collar on the open market but need to collar with “European-style” options rather than American style. This way your stock can’t be called away from you until the expiration date (as opposed to American style). Even though you can’t do this on the open market there are plenty of brokers who are happy to arrange this. When you sell a company you will be inundated with phone calls from brokers offering their services. Normally insurance companies take the other side of the transaction.
thanks for that clarificationi probably should have talked about european and american style optionsbut i like to keep these posts short and simple
Ah yes, this brings back memories of a costless collar on WinStar, back in the day, where the counterparty was Bear Stearns. Worked out well, but how things change. The moral of the story: timing is everything, even when hedging.
Love the practical translation of stock speak Fred, reminds me of Too big to Fail in English, a tip of the hat to Dave Pinsen. This post is right up Dave’s alley with products like Portfolio Armor and Short Screen.Dave’s got an iPhone App about to come out as well.
Nevermind, Dave posted a link to the app above
Thanks a lot for the mention, Mark. The iPhone App version of Portfolio Armor is designed to help investors hedge, by showing them the optimal put options to buy to get the level of protection they want at the lowest cost. Here’s a screen shot and video demonstration of it: Things to come, Part II.
Anytime Dave.Fred’s post immediately fired off thoughts of your investment tools
Definitely ties in with the post. I’m almost surprised Fred didn’t mention it himself, since he’s demoed Portfolio Armor before.BTW, we’ve been planning on building out the site to facilitate collars as well. A few projects are ahead of that in the queue though.
If I short a stock I already own, why would this not be a constructive sale and require me to recognize my gain at that point and pay cap gains tax (15% plus state taxes)?
Yes, they changed the rules in 1997. Before that you could “short against the box” and not pay taxes.I’m afraid the advice in this piece is outdated — if you follow the short strategy recommended in teh third paragraph, you will owe capital gains taxes.
Great plain english explanation of how to use options as a hedge, Fred, but I’d love to hear your thoughts on hedging other kinds of risk (especially in context of recent conversations on diversification and such). If you’re building a truly diversified portfolio of hedged assets, you have to think about hedging things like interest rate risk, commodity shocks, etc. Maybe another post sometime?Also, seeing as how we’re talking about using puts as a hedge on stock portfolios, now would be a good time to mention that, before you put one on, you should really do some research. A lot of folks bought “portfolio insurance” back in 1986/1987 without thinking through what that really meant. It was pitched as a perfect downside solution. Then, when the market started falling and the algorithms took over we got one of the biggest crashes in history as portfolio insurance contracts hit the market in wave after wave of uncontrolled selling. Options are tricky, volatile beasts, and probably not the best thing for naive investors.Personally, I generally prefer to either short out the broader market component of a stock I really like (either by shorting the sector or the broader market), or reduce my position as I see a change in the dynamics. That gives me more control over what I’m actually hedging, and doesn’t expose me to options volatility.
great comment. shorting the market and holding the stock is something i should have discussed
There’s a saying: “Hedging is taking on twice the risk for half the return.”
Correlation and systemic risk are the thing to consider when hedging.Example: I work for a great company that is stronger than its direct competition but the overall sector is over priced, or the economy in trouble…. I can then short a basket of my competitors stocks in order to hedge against the industry valuation while keeping a relative upside on my firm.This is Extracting the specific value (the Alpha) versus the market exposure (the Beta). Most firms or CEO use this technique on stocks they are restricted to sell.In Europe there is another mitigation technique for restricted sellers (founders); a fund is created and the promotor approaches 50+ startups founders who exchange (option contract usually) a piece of their startup against a piece of the newly created basket. Two great effects: risk mitigation and creation of a great network for creation of value and partnersips for your firm.
Very interesting hedge methodology. Thanks for sharing this strategy Jerome, it makes perfect sense but wasn’t immediately obvious to me.
That doesn’t just cancel out most of the market risk, but most of the industry risk as well. I’ve been trying my hand at something similar with pairs trades, e.g., this one I exited a little too early.
hi jerome, nice to hear from youi have been tempted to do a trade like that a few times (short the sector, hold the stock) but can never get the courage to take the risk that the sector goes up and the stock goes down
Since there are very few IPO’s currently and most tech takeouts are coming from Apple, Google, Microsoft, Cisco etc… the use of apple as an example is somewhat germane. If you get stock in Apple – you can follow the blog and you get a reasonable answer. However, if you are not talking about some of the most liquid names in the world, options trading is extremely difficult and has gotten more so of late. Try hedging a substantial position on a $1B market cap stock – good luck getting a quote. With the demise of many options floor traders – and big investment banks derisking their balance sheets – even larger hedge funds (like the one I work at) have difficulty trading options efficiently on $1B – $5B equity market cap companies.I do think founders are having an easier time of it – at least from the peanut gallery here. We see more and more late stage deals allowing for some cash out – and any underwriter will certainly lend you $ against your stake in the company – if public (it’s called a margin loan).As far as echange funds – they are a very difficult situation. I always thought that a founder giving up a little more of his or her ownership in return for a stake in other portfolio companies that VC’s have makes some intuitive sense – but then how do you value those stakes? Cost or market? Whose marks? As Fred says, it becomes somewhat self selecting in an adverse way. Right now, I’d be happy to let USV have more of a start-up – as a VC – if I thought I could get some stake in Twitter at USV’s cost. Not exactly fair to USV’s LP’s.Better to do it outside of the company – or the VC’s that fund it. If you could find 50 CEO’s who all could agree on their price – I’d say go for it – but good luck getting them all together on price.
Good post.It does amaze me at how companies that are under a $5B market cap seem too small to bother with on Wall Street. $1B are quaint. It was less than 15 years ago you had interesting technology companies trading that only had to be bigger than $100M. That’s the only way to get people together on price….have a market.I still don’t understand how much of what’s done on Wall Street doesn’t just constitute gambling. I’m fine with shorts, I understand buying and selling options, and have no problem the futures market. I understand all of that when you are protecting a position like Fred or SoutwestAirlines, or Budweiser. I don’t understand being able to just bet on the price of something without having a position (long or short) on it.For instance this quote from today’s NYTimes seemed really strange:Pershing also owns an additional 14.9 percent interest in Landry’s through cash-settled derivatives. These derivatives track the shares of Landry’s, but Pershing never owns the actual shares. Instead, if the shares go up, the banks that sold them simply will pay out the gain to Pershing. If the shares go down, Pershing will pay the loss to the banks.
Doesn’t that seem like a weird weird and wrong sort of inflation to you? You can’t go up forever- it smells of smoke and dilution.
Options are definitely appropriate for those who do technical analysis on a daily trading cycle. It is also your best friend if you happened to be part of that stupendous stock dive back in May.There was a story about a trader back in the 90s who lost around $900,000 “as lunch money”. He went out of his office to grab a bite; not knowing that during that time he went out, his entire office was hitting market pandemonium. Long story short, it is always best to put a stop on the price just in case something out of the ordinary (which can and has always) happens.Funny you mentioned fees. Back during the advent of trading platforms, a former mentor was trying to sell a lot after it has reached its price. He kept canceling the sell transaction because he was wondering why there was a mysterious amount deducted everytime he hit the very last button. One thing he learned that day despite the hustle: slippage fees.Awesome post, Fred.Take care of the downside, and the upside will take care all by itself -The Donald(?)
Fred, Thanks for finally revealing your inner options geek! If anyone is interested in a pretty deep discussion about the collar trade under different market conditions, check out “Collaring the Cube: Protection Options for a QQQ ETF Portfolio” by Szado et. al: http://papers.ssrn.com/sol3…Eric
Lotta math here…this is where the geeks go, that and bonds.
Speaking of hedging, the Supreme Court just ruled on the Bilski business method patent case which involved whether you could patent services based on hedging methods. They upheld business method patents.http://www.nytimes.com/2010…
i have not read up on the Bilski opinioni need to do thatwhat i heard was that they “punted” and didn’t necessarily uphold business method patents
“What constitutes that these days is another issue.”Ha ha!
The verb ‘to hedge’ derives from the noun hedge, i.e. a fence made from a row of bushes or trees.To hedge a piece of land was to limit its size….and was effective at keeping intruders off of one’s property.This developed into “hedging” other property, to make them more limited, more secure, and less susceptible to external risk.
Mark Cuban was able to do this successfully during the dot-com bubble.http://www.optionsmentoring…If you are sitting on some large gains, it’s prudent to hedge.
Cuban didn’t just successfully hedge during the dot-com bubble; he also hedged with DIA puts before the crash in 2008. Not too many other folks come to mind who made a bundle during the dot-com bubble, hedged to project their gains, and then successfully hedged before the worst of the financial crash in ’08. Mark Cuban is a rare breed.
I know this does not fit this topic or that you might have already discussed this – but, I just read an interesting article about the demise of the IPO and ways to fix it – http://online.wsj.com/artic…Was wondering your thoughts – if they got this right and could more dutch auctions be brought to market given our current legislation and their supposed hatred of Wall Street?
Couldn’t you do some very funny things with hedges- like play the bond against the stock depending on how you can work your counterparty risk? How would that work? Also, since I looked up the difference between American versus European options, how do you manage time as a factor, particular with Americans? With europeans, I guess you just buy in sets until they expire on the dates you need.Also what happens when they expire- since it only indicates a right to buy- what if no one buys, then what happens?
Thanks Fred! Love these “MBA Mondays” posts.
Fred,Thanks for your thoughts.One minor point; you write: “If that happens, you actually are getting $223/share because you’ll get $250/share but you had to pay $27 for the call.” But I believe you meant “…pay $27 for the put.”Also, having been through this as a small LP in a number of funds, while I did eventually receive distributions in shares, I pledged in my LP agreement not to “hypothecate”, or otherwise to hedge, shares that I had not yet received (even though I could calculate what I would be receiving once lockups expired). So I find it interesting to read that, in your fund, you have situations where you are indeed allowed to hedge positions that you can not yet exit.Best,Martin
i don’t know if we have that provision in our LP agreement, but i do think it is better for the entity that owns the underlying stock to do the hedge
This great post finally inspired me to figure out how to use the comment system.
Thanks for the practical explanation. I often tried to explain the concept to many friends in a different arena when I worked at a public company and all of their salary came from the company, much of their upside was in company stock options and most of their retirement savings was in company matching stock in their 401K.
By way of example, here is how a few hedges of mine performed today, with the drop in the market:Puts bought as hedges:SPY100918P00096000 4:00PM EDT 3.26 Up 1.16 Up 55.24%<sup>1</sup>DIA100918P00089000 3:59PM EDT 2.50 Up 0.84 Up 50.60%Those were the optimal puts for hedging when I bought them — the ones that gave me the precise level of protection I wanted at the lowest cost. You can find your own optimal for hedging with the Portfolio Armor iOS app.
Fred,I’ve been really enjoying these posts. On a completely unrelated note, I have been thinking about seed to early-stage investments and how VCs are able to come to a proper valuation for companies that are pre-revenue. I’m not sure this is worthy of an MBA Mondays post, but I think it is something that would provide an interesting discussion. I would venture to guess (as I am completely inexperienced in seed investing) that a VC will provide funding that allows the company to survive for ‘x’ months for a certain percentage in the firm — I would assume pre- and post-money valuations are more the result of amount invested and percentage of ownership as opposed to drivers of amount invested and percentage of ownership.I apologize if I’m not being clear here, but that is primarily due to my lack of knowledge on the subject. Thoughts/ideas would be much appreciated.
I don’t like exchange funds charlie. First round capital has done this. Ithink they are a bad deal for the best entrepreneurs and would be perceivedas a tax if they were forced to participate. If participation was optionalyou’d see adverse selection at work
It’s called the “hedge by marriage”, Charlie.Marry someone with a day job.;-)
I did already … my avatar :-).Yes. why not in the form of secondary market !! there is secondary market for VCs !!! why not for the guys who burn their finger and a** ?
I don’t understand why it is presupposed that entrepreneurs and founders are entitled to hedge their position… or rather, to have their position hedged for them? It’s how one chooses to make one’s living, and in this case the upside is higher. How is the entrepreneur’s position different from, say, a postal worker who makes his or her living from an enterprise that could become obsolete? Or an automechanic whose business is threatened by Detroit’s financial woes or Toyota’s flawed technology? For that matter, how is an entrepreneur’s position, in this regard, different from Wall Street professions that fluctuate with the markets, over which individual practitioners have no control? If anything, founding entrepreneurs have direct influence over the success or failure of their projects.
I really like the idea in theory but its so tough in practice, mainly its a timing and valuation issue.Timing because all companies would have to be at the same place….if I was getting a bunch of traction I wouldn’t want to trade shares for a raw startup..Valuation because sometimes I see a company at EO and think wow what a great company (or what a crappy company) I would want one and couldn’t care less about the other.Finally, I agree with adverse seletion the guys/gals at the great companies generally are just keeping their heads down running a great business they don’t want to trade shares, the guys that are struggling will do anything.The best you can do is have a serious Chinese Wall like JLM suggests. There of course are two problems with that….the first is that it presupposes you’ve had a success and invested well. The second is one I’ve never been able to get around is personal guarantees for lines of credit.
Sounds like something Second Market could facilitate.
The answer to that first question is only knowable in hindsight
I agree necessity brings on the boldness we need to make the ask!
Also it bears mentioning that if one employs the tactic of hedging via marriage, that use of collars, while possibly exciting, is best kept private.
What’s “csa” stand for?
And right now that can happen, but only after a successful exit and angel investing. I think it’s an interesting dynamic, but could have negative consequences.For instance what if I’m a founder of middle of the pack performer. I have a few percent of twitter which explodes in value. Now I’m willing to take an earlier smaller exit for my business, since the financial motivator has diminished and I see more upside in starting overI still think it’s an intriguing idea. Reality and timing can strike your business down with imperceptible speed.The easiest way to implement this with least paperwork headaches is to allow founders to exchange a small share of their stock for cash and let them buy in. This does mean taxation though. The alternative of tracking all the various shares of companies would be a challenging logistics problem although well worth the paper pile compared to Uncle Sam. Could inspire some new startups to track startup shares or liquidate them in a new market (taxable?)
1) auto workers can hedge the same as auto CEOs. 2) when risks are transfered from a party who can’t bear them to someone who wants them, both benefit.Creating and maintaining the right incentives is a pretty tough nut though. Imperfect humans combined with free markets don’t always make it easier.
This is to avoid insider trading =)
community supported agriculture.it’s actually quite a propos to this topic, as it is a hedge, or risk mitigation strategy, for local farmers who by definition have volatile yields and also to deal with seasonality. but the participants don’t want that to drive the farmer out of business.you buy shares in the CSA, in some cases contribute work, and you participate in the bounty…which is typically excellent quality.http://www.prairielandcsa.o…
OK, thanks.
My example might not make much sense (admit it sounded weak to me), but I’m trying to imagine it from an investors pov.As to demotivating, I don’t think I would be the list bit demotivated by diversifying shares in other startups either (love the idea of investing in startups). Perhaps there’s a pattern.
I think it would have to be higher because assuming you have 20 companies and a home-run gets diluted by additional rounds the share of a $100M exit would be $50k which doesn’t seem too much. Of course a billion dollar moon shot would be interesting.It is an interesting concept because I think what some people don’t understand is that as an early stage entrepreneur you have it all on the line. In every other profession including VC people pay themselves much more which is taking risk off the table and aren’t the ones that go without a paycheck if things get tight.Also as I point out if you need a line of credit guaranteed its your house on the line so you’re not funding somebody’s salary with your own house.But the challenge is do I want to give up 10% of my company to others I don’t think are as good. By definition every entrepreneur must believe that because if you didn’t think you were better than almost everybody you couldn’t get out of bed in the morning. The counter side is that we all agree there is a thing called luck/timing or whatever you call it and it would be nice to be the beneficiary on the good side of that equation.I have brought this concept up a EO and talked to several founders….we could never get together on it. That said I wish First Round the best and want Josh to be able to shout out an “I told you so” and applaud him for trying because that is the true entrepreneurial spirit. Try something everybody says can’t be done and go out and prove them wrong.
the vast majority of secondary shares that are sold these days are by founders not VCs
I remember signing document which says “I have the first right sell and you have ask me before selling”… i am not sure about the technical term/clause … it is probably “first right to sell” OR “Drag-ON” … in-fact i have not understood 50% of the doc but still signed it …because of desperation for investment 🙂 .