Hedging

As always, you can skip this one and go to funner new stuff below.

I'm so confused. Gold (August)spent the week climbing off a 650 low with decent volume. The equity indexes are all up, testing their highs of a couple weeks ago, the NASDAQ100 actually closed over the recent high on Friday. I'll have to wait til tomorrow to see which way the wind blows.

I've been reading what the bankers are saying. They say they're not too concerned about the ten year rate being over 5%, that the housing downturn hasn't hurt the economy as badly as they'd though it might, and the Fed won't have to cut rates to give business a boost. They'd invested in a lot of bonds in case the rate was reduced and bonds got a little over-priced and are coming back down. Not too worry, everything's fine. But then, what would we expect them to say, and are they really that blase' about the money they lost on their bond holdings when the rates went up?

One interesting point was that commenting on the equity markets, they pointed out that large caps do better in volatile markets, and their profits are less sensitive to interest rate fluctuations. Also if rising interest rates worldwide reflect economic growth, large caps which have greater exposure to foreign markets will benefit.

Remember a month or so ago I mentioned hedging. The idea is to buy and sell futures you expect to react differently to the same stimulus. In this case the idea would be to buy the Dow and sell the Russell 2000. If they both go up, the Dow should go up more. If they both go down the Dow should go down less. It would be great if the Dow went up, and the Russell went down, bur that's not likely to happen. It's even less likely that the Russell would go up and the Dow down which would be worst case.

This is where options come in. If you buy a call on the Dow (getting the right but not the obligation, to buy it in the future at a little more than today's price), it costs you some cash. If you sell a call on the Russell (giving someone else the right but not the obligation to purchase the stock from you in the future at a little more than today's price) you get some cash. The cost and the proceeds net out to reduce the cost of your speculation, and you can always hope the Dow will go up enough to make it worthwhile to exercise your option but the Russell will just go up a little, and the buyer of your call won't exercise his. Then you have a profit on your Dow contract and the proceeds of the sale is your profit on the Russell contract.

I shouldn't be so careless in my wording. Above,I talk about "us or them" exercising the option. Well, that's not really going to happen on the long or short side. The market price of the option rises or falls as the price of the underlying index rises or falls. We would plan to have closed out our options at a profit at a point of our choosing well before the expiration date.


Whew, makes my head hurt just thinking about it. But some people do it all the time, and it appears to me that you have a better chance of making money with options this way than if you just go long or short one contract. I'm not going to do it, but I'm going to keep an eye on the Dow vs. the Russell to see if it would have worked out.