Risk being an inherent and precarious element of investing, hedging is basically an investment strategy employed to reduce risk by making a transaction in one market to offset a loss in another. Put more simply, hedging is taking equal and opposite positions in two negatively correlated (meaning if security A goes up, then security B goes down, and vice-versa) securities to lower risk of loss.

Theoretically, a perfect hedge would be one that eliminates all and any risk altogether from an investor’s portfolio, but that would mean there is no potential for upside either. In the real world, therefore, hedging is used by hedge funds preponderantly to reduce volatility and risk while trying to protect principal and deliver positive (absolute) returns under any and all market conditions.

Hedge funds, actually a misnomer as not all investment strategies involve hedging, use a wide variety of alternative strategies to invest. As opposed to mutual funds, hedge funds are exempt from many rules and regulations of the SEC (and also do not have disclosure requirements). This gives hedge funds the flexibility, and advantage, of being able to invest with a wider range of strategies including hedging strategies to protect downside risk.

Some of the hedging techniques, each involving an array of financial implements and each offering different degrees of risk and reward, employed by hedge funds are outlined below and can be utilized by sophisticated individual investors to protect their own portfolio.

SHORT SELLING

While short selling by itself is not a hedging strategy (it is often used, though, as a hedging strategy in the context of a long-only portfolio), it is important to understand it in order to appreciate how it works as one leg of a hedging strategy.

When short selling, an investor sells borrowed shares with the anticipation that the price of the share will decline and with the intent of returning the shares back to the borrower. This is also referred to as taking a short position, as opposed to a long position (i.e. simply buying the security) which is opened in the expectation that the price of a particular stock will rise in the future.

If in actuality the price of the borrowed shares does drop, then the investor profits from buying back the borrowed shares sold and returning them to the borrower at the original price. To further clarify the profit made from a short transaction, let us consider this simple example: Assume that 100 shares are sold short by an investor for $5 a piece and her account is credited for $500. Say the price per share drops, as anticipated by the investor, to $3 and she closes out the position by buying back the 10 borrowed shares for $300. The investor makes a profit of $200, the difference between the short sale, i.e. $500, and the closing of the position, i.e. $300.

This all might seem simple, however, an in-depth analysis has to be undertaken by an investor to arrive at the premise that the price of a particular share will in fact fall and not rise. If the price of the share does increase, the investor will end up with the short end of the stick (no pun intended) and lose money.

Technically, the furthest the price of a share can drop to is zero and hence the upside is limited to the amount of investment, but the downside is theoretically infinite for there is no limit to what the price of a share might rise to. For this very reason the fluctuation in the price of the shares in question is followed with painstaking diligence by the investor. (Not to get ahead of ourselves, a cautious investor can hedge his short-selling risk by purchasing a call option on the same shares.)

LONG/SHORT EQUITY

Hedge funds utilize this strategy which involves buying certain stocks long and selling others short. This strategy was pioneered by Alfred W. Jones who is credited with starting the first hedge fund, A.W. Jones & Co., in 1949. Mr. Jones formulated the idea of hedging stocks by going both long and short with the aim to lessen the effects of market risk by hedging long equity positions with short positions.

To further clarify how market risk is hedged in this strategy, say that an investor might short sell a stock while buying a different one in the same industry. Now if the industry declines overall, then the short position would compensate for the loss acquired in the long position and in the case that the industry stocks rise the reverse would be true.

In either case, however, an astute balancing act has to be performed by the investor in estimating and hedging the risk to market exposure. Market exposure is determined by subtracting short positions from long positions, and the higher the difference (referred to as being ‘net long’), the higher the market risk.

ARBITRAGE

Arbitrage is the practice of simultaneously buying and selling two different, but highly correlated, stocks in the same market to profit from the unjustified disparity in their prices. Conversely, arbitration can be achieved by buying and selling the same stock in different markets and taking advantage of pricing inefficiencies (these opportunities are less and less common in today’s world of electronic trading). Ideally, an arbitrage transaction involves very little (if any) cash outflow and hence has the possibility of a very low-risk profit with very low cost to boot.

Arbitrage, sometimes referred to as ‘risk arbitrage’ or ‘merger arbitrage’, can be applied to special situations where a business is being acquired by, or merging with, another business. When a publicly traded business is being acquired, the acquiring business makes a tender offer – to the shareholders of the business being procured – which is usually higher than the market price. An investor may profit from this situation by buying the shares (at a lower price than the tender offer) of the company being acquired immediately after the tender offer has been announced, and then turning around to sell the shares back to the acquiring company at the tender price.

Practically speaking, the risk involved in jumping into the fray of special situations relies upon two main factors: Will the merger or acquisition go through? And, if it does go through, what will be the amount of the final tender offer? These two risks can be taken head-on and be classified as pre-emptive and post-tender respectively. The former being more risky as it is speculative and visceral because the investor purchases shares based upon the conjecture that the M&A deal will materialize. And assuming that the merger does go through, the final tender price may come in higher or lower than the original tender. (Again, not to get ahead of ourselves, these risks can be mitigated by being long convertible bonds and short the underlying equity.)

OPTIONS

An option, akin to a future, is essentially a derivative. A derivative is anything whose value is based upon some other asset, i.e. it derives its value from something else. Specifically, derivatives are securities whose prices are based on the prices of an underlying asset, namely equities, bonds, real estate, commodities, etc. Derivatives are prominently used to hedge and reduce risk of an investment in the underlying security. Besides futures, the most common derivatives used for hedging are options which are used to develop a hedging strategy where a loss in an investment can be offset by a gain in the option contract.

There are myriad ways of using options to hedge a portfolio. One common use of options is to curtail the possibility of losses in a specific security. An investment can be protected by buying a put option on it — this gives the investor the right to sell the investment at a specified price (known as the strike price) for a specified time period. Now, if the stock price falls below the strike price, then the losses can be compensated for by gains in the put option (meaning one does not have to exercise the put option). In the same fashion, a call option can be used to hedge losses arising from a short position in a stock, as the call option gives the investor the right to buy the stock at a specified price.

RELATED ARTICLES

• Options Strategy: Short Call
• Options Strategy: Short Strangle

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Bloomberg News reported this morning that hedge funds as a whole had another awful year. (I had actually tweeted about this late last week) While the S&P 500 had a total return of about 30% during 2013, hedge funds limped in at about 7% (see chart above).

To make matters worse, hedge funds as a whole have had a dismal record since the global credit crisis and Great Recession of 2008. Up to that point, good performance and a market blitz by the hedge fund industry seduced a lot of capital to invest. It was hard for many to resist the siren call of having a chance to invest with a group of “geniuses” that had bolted from their previous employ as mutual fund managers or desk traders to form their own firms.

However, the tide as long since receded, revealing the true legitimacy of a lot of the industry’s talent and trading strategies. Excessive fees, once overlooked as hedge funds had a good early run, are now the topic of constant examination.

Now, it is true that there are a number of excellent hedge fund managers still in business (as there were before hedge fund investing started to become a fad in the later 1990’s), but their success and skill is drowned out when looking after the various hedge fund indices that include a broad array of participants. However, trying to isolate these excellent managers is a bit like looking for a needle in a haystack.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. 

Richardson GMP Limited, Member Canadian Investor Protection Fund.

Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

Pardon my hypocrisy for just one second, but everyone needs to shut up about Edward Snowden.

Don’t get me wrong – the man did a service to the American people. He exposed the raping of our Constitution and deserves a metal, as far as I’m concerned. Despite what the government wants you to think, Snowden is not a traitor: he is a patriot.

But after all is said and done, Edward Snowden is nothing more than a smoke screen in the face of the American people and only serves as an example of how apathetic the American public has become.

Real Crime

Politicians are pick-pockets – it’s all about keeping the attention focused elsewhere. A good pick-pocket will bump you with his shoulder or place his palm on your back as his other hand steals your wallet right from under your nose. Even if you do notice what just happened, the criminal has already passed off the stolen goods to his partner walking in the other direction.

You can fret and fuss, but after all is said and done, you’re not going to get your wallet back.
This is exactly what is going on with the whole PRISM scandal. We have been told, “Look over there!” and have already forgotten about the government’s total disregard for privacy and probable cause.

I guess a manhunt is more important than our basic liberties…

If you are wondering what the hell happened to this country, I can answer that question in one word: complacency.

As a whole, this nation has become far too comfortable. We are very good at achieving temporary outrage, but after all the hype dies down, we forget about the issue every time. The bottom line is, despite freedom being an inherent right, someone is going to take it away if you don’t fight for it.

But change requires action, and that’s apparently too much work for most Americans.

The fact is, Edward Snowden didn’t give Americans their privacy back – he’s only proven how much they don’t actually care about it.

The Search for Privacy

I had someone tell me this weekend that Edward Snowden has unintentionally destroyed Google (NASDAQ: GOOG). He pointed out that private search engine traffic has increased surrounding the PRISM scandal. People are seeking more ways to search the web without being tracked by the NSA.

Unlike Google, private search engines such as DuckDuckGo and Ixquick do not save data that can be linked to users. These companies do keep data to improve their engines, but no information is ever linked to an IP address.

If you use one of these search engines, feel free and clear; the NSA cannot track your data. In fact, it won’t even try at all. Google, Facebook (NASDAQ: FB), and Yahoo (NASDAQ: YHOO) have admittedly received thousands of government inquiries regarding information stored in their databases, while DuckDuckGo has received zero.

The stock market is currently “priced for perfection” and will have a nasty correction if anything “goes wrong”…and there are plenty of things that could “go wrong.” For instance, the stock market has been so enthusiastically bullish that it seems to have forgotten all about “Geo-Political Risk”…which would make a blow-up somewhere all the more shocking…and then there’s credit and currency market risk to worry about…I’m not short the  stock market…it’s a raging bull market…but conditions are ripe for a sharp break and I’m watching for the opportunity to get short…actually, I’m not just looking for the stock market to break…I’m looking for “Leverage” to get hit…let me explain what I mean.

When I say that “conditions are ripe for a sharp break” I’m looking at the market in terms of Market Psychology…remember this, markets go up and down, in different time frames, as Market Psychology changes. Five years of extremely simulative global monetary policies have produced 5 years of rising share prices (yes, there is a direct correlation!)…and Market Psychology has become very bullish. 

When Market Psychology is bullish people use leverage…as bullish enthusiasm intensifies people use more leverage…exacerbating the market’s rise.

When Market Psychology turns bearish leverage is reduced…voluntarily or otherwise…and that reduction exacerbates the market’s fall.

The degree of bullish or bearish Market Psychology could be measured by the use of leverage…and the use of leverage, in so many different forms, has been increasing. For instance, share prices are rising because P/E ratios are rising…people are willing to pay more for a dollar of earnings. Margin debt, the amount of money people borrow to buy stocks, is at an All Time High.

So here we are…after five years of rising prices…at All Time Highs…priced for perfection…and clearly not prepared for anything to go wrong. While it’s impossible to predict “when” a “Black Swan” or “Third Derivative” event will hit the market it is possible to make some guesses as to “where” the nasty surprise might originate:

1)      The credit markets:

The Federal Reserve has begun to reduce their stimulative monetary policies…this is the beginning of credit tightening…(They do “Ring A Bell – Don’t Fight the Fed”) and the effects of this action will ripple around the world…perhaps inducing something to “go wrong.” For instance, Mark Carney, former Governor of the Bank of Canada and now head of the Bank of England sees the Shadow Banking Systems in emerging markets as a key source of market risk. Shadow banking systems provide credit when traditional sources won’t…and are very vulnerable to changes in credit conditions. For instance, credit growth in China has expanded at a ferocious rate since 2009…from $9  Trillion to $24 Trillion…more than the combined credit growth of both the USA and Japan…the Chinese authorities are now trying to reign in credit growth…and Shadow Banking practices have surged in China.

2)      Geo-Political risk:

It seems we’ve nearly forgotten about geo-political risk…which would make a blow-up somewhere all the more shocking…tensions are ramping up between China and Japan…Turkey’s political problems could take a turn for the worse…then there’s Egypt, Syria…Israel/Iran, the Olympics in Russia…

3)      The currency markets:

Last week Korea “went public” with their frustration over the Japanese “weak Yen” policy and threatened direct market intervention to keep their currency from rising against the Yen. Clearly the Japanese expected the Yen to fall as a result of their simulative practices…they hoped that a weaker Yen would allow them to export more…but Korea (and many other countries) see the “weak Yen” policy as unfair competition.  I expect escalating “currency wars” in 2014 (and other “beggar thy neighbor” protectionist policies) which could trigger a hit to over-leveraged markets. 

What am I doing in the markets right now…what trades am I anticipating?

I’m not long stocks, but I’m not short either…as much as I think a nasty correction is over-due I respect the momentum of the bull run…but I’m watching closely for signs of weakness and I will get short stocks if I see a confirmation that the bull run is breaking. I see the weak Yen and the strong stock market as two sides of the same coin. If stocks start to break I’d expect the Yen to rally. The Yen has fallen much more against the Euro than against the US Dollar over the past year…if Market Psychology turns negative then the Yen could have a huge rally against the Euro. As much as I think interest rates are headed higher in 2014 I’d look for bonds to rally if stocks break. I’m currently long the US Dollar Index.

The US Dollar Index:  I caught a good rally in the USD from late October into early November…exited the trade when the market struggled at 8150…I`ve been looking for a good spot to re-establish the trade…bought the Dollar and got stopped out a couple of times…bought it again last week…so far so good. A rally above 8100 would increase my comfort level…I’d look to add to my position if the market can clear 8150. In terms of keeping the time frame of my trading in sync with the time frame of my analysis, I’m looking for the USD to rally for the next few years. 

The S+P 500 stock Index: As noted above this market is “priced for perfection.” I’m not short…I have to respect the momentum of a powerful bull market…but…Market Psychology is very bullish…leaving this market ripe for a correction. So, in terms of my RAWCTER method (Research the market…Anticipate either a trend continuation or a reversal…Wait for a Confirmation…that the Time has come…to Enter the market…with Risk Management parameters) I’m “Anticipating” a trend reversal but I’m in “Wait for Confirmation” mode. 

The Japanese Yen (in terms of the US Dollar): The Yen began a steep decline in late 2012 when Market Psychology anticipated that Abe would win the election and begin to implement his policies to end two decades of deflation in Japan…one of his “three arrows” was to have the BOJ ramp up the Yen money supply…this tidal wave of liquidity didn’t stay in Japan but went international…helping to drive world stock markets higher. The falling Japanese Yen and rising global stock markets have been two sides of the same coin…if stocks start to fall I look for the Yen to rally…remember May/June 2013…(circled area below) hedge funds had been short the Yen and long Japanese stocks…the trade was a “lay-up” and they had it on in size…as the Yen went into a counter-trend rally stock markets (particularly Japanese stocks) tumbled. If the Yen reverses from current levels I’d expect a bigger rally than last May/June.

The Japanese Yen (in terms of the Euro currency): While the US Dollar has rallied ~34% against the Yen since October 2012 the Euro has rallied ~45%…if the Yen begins to rally (spurred by a leverage reversal) then I’d look for EURJPY to fall harder than USDJPY. 

Comex Gold: At last week’s lows gold was down nearly $750 (39%) from its Sept 2011 All Time Highs of $1920…the year 2013 was the first year since 2000 that gold closed lower on the year. Gold has truly been “out of favor” the last two years while stocks have been very much “in favor”…in terms of the S+P 500 gold has fallen nearly 60% since Sept 2011…if “Leverage” takes a hit gold could break to new lows…but…could gain in terms of stocks. My “most likely” scenario for 2014 would see gold make new lows but close higher on the year…without making a new All Time High…that will come later.

The Canadian Dollar: Over the past few years I’ve switched about 1/3rd of my net worth from CAD to USD at an average rate of around par…as a currency diversification move…I don’t want to have 100% of my net worth in any one currency. I was lucky enough to be in the right place at the right time when CAD rallied from around 60 cents to above par on the back of the 10 year commodity bull market. One of the best currency trades I made in 2013 was my son Drew’s idea…we sold AUD against the CAD as the AUD fell harder than the CAD as commodity markets weakened (and as the Governor of the RBA “talked down” the AUD.)

The US 10 Year Bond: US long term interest rates hit lifetime lows as bond price peaked in 2012. In May of 2013 I listened to David Rosenberg tell attendees at John Mauldin’s Carlsbad Conference that he had ended his 25 year love affair with the bond market. (Another one of my favorite analysts, Gary Shilling, spoke at the same conference and he remains bullish bonds.) Market Psychology is currently very bearish bonds. If “Leverage” takes a hit and stocks tumble then the bond market will rally.  

by Rick Bekkering Investment Advisor

The tax loss season is behind us and the resource sector hasn’t seen a beat down like the past couple years since the “Rumble in the Jungle” in 1974 Zaire between Foreman and Ali. Within the resource sector there are many sub sectors and market capitalized companies. You have the Large capitalized companies over 10 billion, Mid Cap. at 2-10 billion, Small Cap. at less than 2 billion and finally Micro-cap. Then you have different types of commodities ranging from precious metals (Platinum, Gold, and Silver) to the base metals complex (iron, nickel, lead, copper). There are Energy stocks (Oil, Gas, and Uranium) to name a few and lumber stocks…the list goes on.

Within the different resource groups there are also various business sectors that are affected directly from production. Needless to say Cyclical investing in the resource sector is anything but easy. And it has a lot less to do with the commodity price then it would appear on the service. The perfect example is what we are seeing today with high Gold prices and gold stocks skipping off major if not all time lows.

So how to help “invest” in the resource sector when considering all the choices most I.A’s and portfolio managers will perform stock valuations. In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.

In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as “predictions of future cash flows/profits (fundamental)”, together with “what will the market pay for these profits?” These can be seen as “supply and demand” sides – what underlies the supply (of stock), and what drives the (market) demand for stock?

Some of the ratio’s to compare from company to company are redily available from your broker or advisor and are Price/Book Value Ratio, Price/Cash Flow Ratio, Price/Earnings Ratio/Price/Sales Ratio and Dividend Yield. I like Debt/Equity as well.

Rick Bekkering is an Investment Advisor in Kelowna BC and can be reached at

1 855 478 1590 or at www.Rickbekkering.com