Rebel Traders 043 : Trimming the Hedge

It’s time to trim the hedge and add a little bit of risk mitigation to your trades and the Rebel Traders show you how...

We’re all about risk mitigation and our strategies allow us to do that while still maintaining all the upside. Somethings, though, you need a wee bit of a hedge and in this episode of Rebel Traders we show you how…

Sean, Phil are joined by Andrew Page, our resident master of the futures and with three heads being better than two, they discuss their strategies for when to hedge, why to hedge and just how they do it.

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Sean Donahoe: Get out the chainsaws ladies and gentlemen, we're trimming the hedge, let's rock.
Automated: Rebel Traders takes you inside the world of two underground master trainers, who take an entertaining and contrarian looking at the markets to cut through the noise of Wall Street and help you navigate the trading minefield. Together, Sean Donahoe and Phil Newton are on a mission to give you the unfair advantage of a Rebel Trader. Now, here are your hosts, Sean Donahoe and Mr. Phil Newton.
Sean Donahoe: Hey, hey, hey, ladies and gentleman. This is Sean Donahoe and welcome to the Rebel Traders Podcast. I am joined by two experts in the field of trading today, our resident master of the futures, Mr. Andrew Paige, and our regular partner in podcasting, the powerhouse farm boy, Mr. Phil Newton. How you doing, sir?
Phil Newton: I'm absolutely fabulous.
Sean Donahoe: Fabulous.
Phil Newton: I like the way Andrew got the master and I got the kind of okay poor farm boy. He gets the accolades.
Sean Donahoe: I prefaced it with powerhouse, the powerhouse farm boy.
Phil Newton: I didn't hear that bit. In fairness, Andrew needs his ego , I know I'm fabulous.
Sean Donahoe: There you go. There you go.
Andrew Page: Yeah, totally.
Sean Donahoe: This is going to go downhill before we even start. Anyway, in today's show, you know guys that we are all about risk mitigation. Our strategies allow us to do that, while still maintaining all the upside. Sometimes though, you need a wee bit of a hedge in this. In this episode we've got here today, we're going to be talking about that. The Rebel Traders, me, Phil, and Andrew are going to be showing you how, talking about strategies, the considerations in and around that, and lots of other things, as well.
Phil Newton: We've also got the Rebel Trader mail banquet, your trading questions are answered, with a continued favorite section of mine is the bullshit of the week, we call it the hype, the hyperbole, the shenanigans, all the nonsense and the usual tomfoolery of the industry. Somewhere amongst all of our own nonsense, we're going to find and answer the core question of, "Where is the trade?"
Sean Donahoe: Awesome stuff. Okay, so let's jump into this topic. I think we need to preface hedging a little bit. We were talking about this just before I started recording this show, about the entire area of hedging is kind of a dodgy topic.
Phil Newton: It means different things to different people, I think, yeah.
Sean Donahoe: Yeah. I was going to say, I think we need to come up with a little bit of a definition of what hedging actually means. We're not talking about bushes and shrubbery, we are talking about risk mitigation by placing basically one trade against another to give you some sort of extra protection of your position. It is kind of an advanced topic and we are going to get a little bit geeky here, a little bit in-depth, but you also need to understand, and we'll talk about this a little bit later on in more detail, of what your purpose is for wanting to place a hedge.
Where does hedging actually come from? We talk about people here hedging, they think, "Hedge funds," but a lot of funds, or hedge funds, don't actually hedge their positions.
Phil Newton: I think, in my mind, a hedge funds was always to, or a hedge, a true hedge, in my mind, was always to reduce the directional risk. If you were bullish on a particular stock or a trade idea, then you would find something to counter that, to remove the direction or risk, maybe something in the same industry or something that had an inverse relationship. So that if your trade idea was wrong, you would still end up being right somewhere, or the risk was reduced or minimized because you'd hedged against it. That was always my idea of what hedging was. Again, there's lots of different interpretations and variations, depending on your overall objective and strategy, and why you're doing it in the first place, but that was kind of like my first understanding is to reduce that or remove as much as possible the directional risk on your trade idea.
Sean Donahoe: Yeah, that's pretty much my understanding. That's the way I would interpret it, too, but Andrew, what's your comments on that side of things?
Andrew Page: Definitely. From a future perspective and commodities perspective, hedging is huge. Again, I think that Phil just nailed it on the head, you are using a trade to protect against an adverse directional movement. Farmers all the time, they're growing crops, they're worried about falling prices, say some guy's growing wheat, he'll short some futures contract to protect his crop value. He's not looking to make money speculating on where the price of wheat is going to be in a month, his job is growing it. He doesn't want to worry about that headache, so he -
Phil Newton: He just wants to make sure he gets a good price, yeah.
Andrew Page: Yeah. It's really good for the farmers and it's really good for the consumers because we have stable food prices, and that is why.
Phil Newton: It would be uproar if the price on the consumer shelf of an everyday commodity, sugar, milk, bread, if that started going through the roof because of volatility, because a farmer is, for example, not able to hedge their positions, then that's where it would translate for the everyday person. In a small way, we see that at the fuel pumps because of the roller coaster ride that oil goes through, we see sometimes sky high prices at the fuel pumps, and exceptionally low prices at the fuel pumps. That's how we, as the everyday person, kind of sees this pricing volatility translate to how it impacts our pockets. If we have a more effective hedging vehicle for the markets or the producer side of things to kind of stabilize the price, then we wouldn't see that wild fluctuation, as we see the stability in things like sugar, and bread, and milk, and all the other things that we like an ice stable price.
Let's face it, our Starbucks is already too expensive. If it was more expensive, it would be ridiculous.
Andrew Page: Yeah. Back before the real commodities exchanges got off the ground, particularly in the US, it wasn't uncommon to see 25% swings in a loaf of bread over a couple weeks. Again, at harvest, everything was super cheap because you have it all, and then in planting season, the supplies are diminished and the price swings were just very, very dramatic. That makes planning for a business really hard. Could you imagine if airline companies couldn't hedge their fuel costs? Tickets would be $100 one day and 500 the next.
Phil Newton: We still see that swing in the oil price impacts the airlines, which we're seeing right now. A lot of the airline industries, their share prices are tumbling because the stock price is going up. We do see it in a small way, but you're quite right, we would see exaggerated swings, exaggerated movements, because part of what the airlines, for example, are doing, they're hedging their ticket prices on the futures market to try and stabilize the price of oil that they can pay, and the fuel and all the rest of it. So, yeah, it's a big part of it. It's not just farmers, I suppose, it impacts ... This hedging strategies keep the average price of fuel being purchased for airlines in this case, it keeps it a nice stable average price.
I think that brings us on perhaps something different. The big boys and girls, if you like, are looking for an average price of the commodity and trying to hedge gives them that stability for the overall average price in the long term. The short term fluctuations they're not so concerned about. So, who is concerned about the short term fluctuations? It would be maybe the funds, maybe the retail traders, like you and me, and they may be worried about those swings in prices, and they would be perhaps looking to hedge and use some of these strategies, but not from getting a good price on the commodity, but looking to stabilize the fluctuations in their portfolio.
Sean Donahoe: Absolutely. That kind of brings us on to pairing, so one of the strategies we'll talk about here. Essentially, pairing is offsetting your position with another position in a similar but not the same security.
Phil Newton: Which is the traditional hedge that most people probably have in their minds that we skirted around earlier.
Sean Donahoe: Yeah. Basically, you want to understand the dynamics and the elements, the metrics, that make up the company that you're looking to take a directional position on. Then you want to find another security with basically the same profile, maybe PE ratio, we're going to go into fundamentals here a little bit. So, price book ratio, market cap, sector, maybe historic volatility. If you have a correlation between all of those, then you have a good potential target to create a hedge against. If there's a high correlation, you found a good match, you place a position on your target security and then you short sell the hedge target that you found, to create that paired hedge.
Now, personally, I don't like this method, as while it may offer some short term risk mitigation, there's actually the potential for more risk, as we're having to maintain a stock borrow on that hedge. There are other unpredictable variables in that kind of pairs trade, where if the company you're hedging gets acquired, or the price of the company shoots up, the company that you're using as a hedge, or even gets acquired, it creates all sorts of potential nightmares. Plus, you've got the capital allocation in that risk portfolio right there.
So, Phil, what do you think about that specifically?
Phil Newton: That's essentially the traditional hedge. You've got a trade idea in say, a biotech sector, and you've got a bullish position, you select a stock opportunity that you think is going to appreciate in value, but you're worried about the ... There's that pesky "but", you're worried about the downside risk, so you find a similar stock that you believe won't benefit from the sector rising, for example, that won't join the party. It's a weak stop. So that if your trade idea is wrong, and not only wrong, but the sector as a whole starts to decline, and that's the stock that will benefit from the downside movements. The idea is, is if your trade idea's right, that's going to increase at a greater pace than the stock that you've hedged with, a rising tide lifts all ships type of thing. It probably will appreciate, but you're hoping that it will not move. Or if there is a downward movement, then that downward movement, the hedge will cover the loss and maybe it will make you a little bit of money as well.
You're looking for the rate of change of the bullish move to increase at a faster rate than either side of the position. As you quite rightly said, it can be capital intensive because you've taken a double position, but it can also be doubly wrong, as well. What if the sector as a whole rises at a fast pace, for whatever reason, something interesting might come out in the sector and not only does your trade idea right, but that bad stock is losing money because that's also heading north at an equally fast pace, or maybe even a greater pace because of some unknown news item. There is inherent risks involved. Well, that's the risk with trading. Ultimately, that's what you're talking about. It's a different style of trading all together, looking for that paired type of opportunity. There's nothing wrong with it, I suppose it come down to what do you like doing? I know plenty of traders who have that as their main way of trading, they're looking active for pairs type of trading, finding an undervalued and overvalued related stock to pair up with some type of trading opportunity. It's a good method, but it comes with its own risks. All you're really doing is transferring the risk from one area, and the directional risk, to a different area. There's still risk involved, I think is what you were trying to get to.
Sean Donahoe: Absolutely. Andrew, what do you think?
Andrew Page: I think that's pretty much hitting the nail on the head. Trying to do pairs trading like this with equities is quite difficult because stocks have a natural bias at the upside, and when the market is moving up, generally, just like you said, rising tide lifts all boats. I think that one of the most effective hedges out there is some of these large index funds like SPY and S&P 500. You're really spreading your risk out quite effectively, and I know it's not a pairs trade, but once you have over 25 stocks in your portfolio, your un-systemic risk, which that is the risk of any one stock plummeting, having that affect your portfolio, starts to go down very, very rapidly.
Sean Donahoe: That's very interesting. It's one thing we talk about we talk about a lot, as basically portfolio management, is having a lot of varied positions in different sectors, creating that portfolio that if one stock does get a hit, it's not taking down the rest of your portfolio, so that's one of the ways that we do trade.
Phil Newton: I think it's hedging against the markets might be a way of doing it. Broadly speaking, we're looking to take advantage of the swings in market, and the swings in the market will go up for a few days and go down for a few days, in a perfect world, I appreciate it's not always like that, but that's generally the way the market goes, it will ebb and flow back and forth, swing up, swing down. If you've got a balanced portfolio, those upswings are going to benefit temporarily the bullish stocks that you believe will rise, but then ideally, it doesn't always happen, but ideally, the stocks that you're bearish on, they're not going to rise as much, or hopefully by a small amount. So when that downswing happens, the same thing's true on the bullish, the bullish stocks are not going to be impacted by the downswing in any great magnitudes, but the bearish stocks are going to see that kind of exaggeration of the downward movement. That's what we're trying to achieve, just , and creates I suppose, touching what you were talking about Andrew, is having your own kind of index funds, but it's a strategy index. It's averaged out by the setup and the methodology that you're using to find opportunities.
Andrew Page: Yes, definitely.
Sean Donahoe: Awesome.
Phil Newton: I'm a big advocate of that, to be fair. As you know, I advocate trade small, but frequently. You can also get that pairs ... Just to be a little bit exotic for a moment, you could have multiple strategies, you can pair off trending strategies with say, ranging strategies, or you can pair off different trade ideas in your portfolio. You've got this multiple strategy approach that tries to take advantage of the multitude of market conditions, because we don't know what's going to happen next, we truly don't know what's going to happen next, but if you can benefit, say, a bullish trending strategy, is going to benefit whereas a ranging strategy might not. That's going to kick in when the markets start to oscillate back and forth without really trending. Again, we don't know when that transition's going to happen, so my personal view is I would rather trade through the shaky periods of a strategy, but trade multiple strategies have multiple exposures. On average, the aggregate, the portfolio, it doesn't then matter what happens in the market, as long as something does happen, then you should be profiting somewhere. That, for me, is the ultimate hedge. Then it means that I don't have to worry about hedging.
Sean Donahoe: Yeah. That's exactly it. We'll cover that in a little bit more detail later on.
Phil Newton: I got ahead of myself there, Sean.
Sean Donahoe: No, that's absolutely fine because at the end of the day, yeah, our strategies allow us to have a built in risk mitigation and we kind of have a by the side hedge in the way that we actually set up our portfolios in the first place with our strategies, so we don't per se need to hedge, but we'll get to that in a little more detail in a little bit. I really want to focus on this next one, which I think is one that a lot of people don't know about, but has kind of evolved over time, and that's short boxing, we're shorting against the box, or you might hear it as SETB. Rather than short selling a different company, like we talked about with pairing with the same risk profile, short boxing is a strategy that short sells the same stock. Now, hedge funds and wealthy investors used to use this for tax benefits to avoid capital gains tax, however, it was, as most tax mitigation strategies are, overly abused, and Congress restricted its use and limited a lot of the long term tax benefits because -
Phil Newton: Flippant.
Sean Donahoe: I know. There you go.
Phil Newton: Really, it does not surprise me.
Sean Donahoe: Yeah, exactly. They say they abused them, but it was basically a strategy that a lot high wealth or high net worth investors used to mitigate capital gains, but they said, "Hey, no, that's our money." "No, it's not, it's our money." "No, it should be the government's money." "But, no, it's my money." "No, but it's actually not your money, it should be given to us because we know how to spend it." Don't get me on my soap box.
Phil Newton: It almost sounds like the conversation that Zuckerberg was having with Congress.
Sean Donahoe: Yes, yes. Yeah, basically.
Phil Newton: "No, it's mine." "We want to see it." "Well, you can't have it."
Sean Donahoe: Basically.
Phil Newton:
Sean Donahoe: Basically, yeah. So, as such, the method now is really only used as a short term hedging strategy, rather than a tax mitigation strategy in the long term, but what do you guys think about that? This time I'll give Andrew first crack at this one.
Andrew Page: Yeah. Again, I did know about this strategy. Again, I haven't really focused on it or used it much myself.
Sean Donahoe: No, me neither.
Andrew Page: I know that, yeah, it definitely in the past has been used quite a bit, definitely to, again, avoid those capital gains taxes. Which can be pretty rough if you're selling in the short term. If you sell under a year, the capital gains tax is very high.
Sean Donahoe: It's insane. It is insane.
Andrew Page: Yeah. Over a year, very low. I can definitely see the appeal of using it to kind of collar a position and make it so if the stock goes up or down at that point, you've already locked in your gains and you're just waiting out your tax period so you can pay sometimes up to 25, even 30% less tax.
Sean Donahoe: Yeah, that's just mental as far as I'm concerned. Again, I won't mention my blood tax bill every year because it would make people weep, or it'd make people laugh, I don't know.
Andrew Page: It's all relative.
Sean Donahoe: Abso-bloody-lutely. Phil, what would you say about this?
Phil Newton: Resisting the urge once again, sir. I have some flippant comments. I'm trying to be professional this week and I'm struggling to do it. I've got to admit, I understand the concept of what's being applied here, but not from a tax point of view. I understand the principle that's being used behind. So, you've got, say, a long position, a few thousand, a few million shares, we're talking about big traders here, kind of capping off the tax on profits. The principle behind it is, you've got to position on. Rather than lock profit in, you can short the stock against your position, so you're trading against yourself, essentially. The little guy might interpret that as, "Well, you're just reducing your position size, aren't you?"
Sean Donahoe: Yeah.
Phil Newton: That's essentially what's going on. I understand that as trading around your position, so you might have, say, a core position, but then you might be actively trading both long and shorts around that core position. Let's just say you've got a thousand shares on a stock that you like, if you intend to invest in that, that's the long term view, you might have it for several months, several years, several decades, who knows. To benefit in the short term from the fluctuations, rather than sit through the position, you can scale in and scale out of that position. That would be effectively what the principle is going on here, but not for tax reasons, it would be to trade around the position to benefit from those short term fluctuations in price. That's how I understand the principle that's being used-
Sean Donahoe: That's dead on. Dead on.
Phil Newton: ... I've always known it as trading around the position.
Sean Donahoe: Yeah. Basically, that is exactly what it is, it is a short term, hit those fluctuations before you get in or out of a position.
Phil Newton: It comes down to that, that's the objective. The objective with the short boxing, as you were mentioning there, it is for tax reasons. Whereas what I'm doing is to benefit from the fluctuations in price to increase the bottom line profit.
Sean Donahoe: Yeah, exactly. Now, this kind of goes on to futures hedging here. I'm going to give a little bit of an example here. Here's an example using futures to hedge a portfolio, rather than an individual position, it's kind of what we were skirting around earlier up. Now, say that you have a large portfolio and you have beta weighted against the S&P 500. Now, beta weighting basically means you're basically comparing, or you have the ability to compare, apples to oranges with looking at ... It basically assesses all of your positions relative to a move in the market. Now, we tend to beta weight against the S&P 500 because it's the biggest general bag of stocks in an index. So, regardless of the direction, you want to assess basically the volatility of where you are in your exposure, measured against the main index. The term beta weighting allows us to easily remember that we are weighting one underlying against another as a comparative analysis. I just wanted to define that a little bit for those who are not familiar with beta weighting.
Phil Newton: It's like putting your stocks on the metric system. Everyone's using a different measurement system, the individual stocks, and all you're doing is converting everything to one unit-
Sean Donahoe: Yeah.
Phil Newton: ... so everything's the same. It's like we're going to use the metric system for our weights and measures, that's what we're doing. That's all beta weighting is, it just converts everything to something that can be compared, which was your point.
Sean Donahoe: Absolutely.
Andrew Page:
Phil Newton: Just to add to that, you said S&P 500, that's usually considered as the market. Just a little sidebar to that is that if you just trade NASDAQ stocks, you could use the NASDAQ index to beta weight. You can beta weight against anything you want, but it needs to make sense. If you're just trading the NASDAQ or you're just trading a certain basket in a certain sector, you can be beta weight it to a sector. It just allows you to compare, it doesn't really matter, the idea is just so that you've got an easy way to compare all your positions together.
Andrew Page: The S&P 500 starts out at one, that would be the comparison. Let's say your beta weighted portfolio is 0.3, that just means that you are moving one-third the speed of the market. If you're at 1.5, you're moving 50% faster than the market. When you see those numbers, that's how you interpret them.
Sean Donahoe: Absolutely, yeah. That's a good point I wanted to raise, as well, that's good. Now, if we're using futures as a hedge, and say that you're beta weighted against the S&P 500, the thing is that a lot of the big futures contracts are out of the range of most retail traders. Let's just take the case of the S&P 500 futures market SPX. Each contract has a multiplier of $250, that of the actual index. If the SPX is trading around 2,650, then one contract is 2,650 multiplied by 250, which is $662,500. Not a lot of people have, in the retail traders, are trading those kinds of contracts. Basically-
Phil Newton: So, Sean, how can the little guy get involved? I think that was what you want me to ... How can the poor farm boy in the room ... Why are you telling me this, Sean? How does the poor farm boy in the room use futures to hedge?
Sean Donahoe: Well, you could also go with the E-minis-
Andrew Page: Yeah, and in futures contracts, you don't have to put up the full value, it's generally some smaller amount called margin, which is anywhere from three to 10%, sometimes a little higher if you're trading something really volatile.
Sean Donahoe: Yeah.
Phil Newton: Sidebar to the sidebar, we're not suggesting that you trade leveraged margin-
Sean Donahoe: No.
Phil Newton: ... you only get ... It's like putting a deposit down, you don't need all the money -
Andrew Page: It's a good faith deposit, that's all it is.
Phil Newton: Yeah.
Andrew Page:
Phil Newton: We're not saying that you should leverage it because you only need a fraction of the notional amounts, we're not saying that you should, "Well, I can buy a multiple of 10," we're not saying that. It just allows you to have a ... Like a deposit, as I always like to think about it.
Sean Donahoe: Yeah.
Phil Newton: Just for the poor farm boy in the room, me.
Sean Donahoe: Abso-damn-lutely.
Phil Newton: I think our sidebars have come full circle, Sean.
Sean Donahoe: Absolutely.
Phil Newton:
Sean Donahoe: It's four lefts make a right, yeah.
Phil Newton: Left turn at Albuquerque.
Sean Donahoe: Here's the thing, you do tend to trade full contracts and it's a lot of capital, even if you're doing the deposit version of that, to offset long beta. Now, of course, there are E-minis, the S&P 500 E-mini has a much smaller multiplier at $50, but the same considerations apply, a single E-mini contract at 2,642, as of the close yesterday when we're recording this, would be about $132,000. Obviously you've got your deposits and everything else that you can do in regards to that, but you can use futures to offset your portfolio, but you have to have a pretty significant portfolio to offset against. If you have one contract in place-
Phil Newton: Is it worth it, is I think what you were suggesting there, yeah.
Sean Donahoe: Yeah, exactly.
Phil Newton: Just because you can hedge doesn't mean you should.
Sean Donahoe: Yeah. This is one of the risk factors that is a problem with this is an imperfect. If your hedge is of greater value than your portfolio, then you're buying risk or you're selling risk. Again, the risk factors there, with an imperfect edge, if you don't have enough hedge, or if you've got too much of a hedge, then you're now unbalanced the other way, which is just adding more risk to your profile and your portfolio. Let's start with Phil. Phil, what do you think on this one specifically? Yeah, obviously, it's a little much.
Phil Newton: It makes it nice and simple if you're an advocate of the portfolio approach and that you might have multiple positions. When I say multiple positions, 20, 30, 40, 50 positions, it makes sense, rather than trying to hedge off everything individually, you can just basket the thing off and go to the futures market, and say, "Okay, I'm worried about an adverse movement in my portfolio because it's predominantly a bullish portfolio," as an example of why you might hedge, "And I think there's going to be a retracement in the markets, therefore, I don't want to sit through that ... I don't want to see all my paper profits disappear, so I'm just going to lock it in at this level for the moment because my view is that we're going to see an adverse movement for the next three months." That might be a reason why you would do this.
To make it simple, you can go to the E-mini futures and you can buy a proportional or a full hedge, meaning that you've covered all of your exposure, should there be a downside movement. There's a reason why you would do that, that's the point I was trying to get to. As I interrupted you earlier, just because you can hedge doesn't necessarily mean that you should hedge. In that example, I think that's a perfectly good reason to hedge and to use futures, it keeps it nice and simple, you're transferring the risk. What if it's an unnecessary hedge, what if your concern was just an emotional reaction and the market react the way that you thought it was going to. You're just worried, for example, about losing your paper profits, that's not a reason to hedge. If you've got a justified reason that the market's going to be crazy in the next three or four months, then that's a good enough reason.
I'm tooling around the comments here, Sean, you get what I'm trying to say here?
Sean Donahoe: Absolutely.
Phil Newton: Ultimately, it's a good idea, with a purpose. If you're just worried about losing profits, then that's not a good enough reason to do anything. Probably, you've got too much exposure. You should close positions at that point. Oh, you're just hedging, great idea, it's relevant, it's a nice tool to have in the box. It's not something you're going to use every day. It's not something that you might use every month, but certainly, you might be thinking about it a couple of times a year.
Sean Donahoe: It depends if you've longed a certain portfolio and then Trump makes a tweet.
Andrew Page: Yeah.
Phil Newton: I would argue that's probably nothing to worry about and -
Sean Donahoe: Indeed. I'm joking.
Phil Newton: ... the time horizons that ... I know, but the time horizons that we're talking about of why you would hedge in the first place, you're probably going to be looking at holding positions for many months, many years. So, a random tweet or an unexplained event over the weekend causes the markets to jump adversely on a Monday, it's probably nothing to worry about.
Sean Donahoe: Indeed. Indeed. Andrew, what do you think, sir?
Andrew Page: I think that basically hits the nail on the head. Phil just speaks so much he gets all my talking points out and I just have to repeat everything.
Phil Newton: Maybe I was looking over your shoulder at your notes.
Sean Donahoe: That's it.
Phil Newton: If anything, Andrew, I feel validated by your comments.
Andrew Page: You should. Everything that I wanted to explain.
Phil Newton: That's what I was trying to say.
Andrew Page: Yeah.
Phil Newton: Shut up for a moment, Phil, I could have said exactly the same, probably in less words.
Sean Donahoe: Funny stuff. Well, if that's the case, let's move on to then the flip side of futures hedging, which is ETFs. Now, ETFs allows us to do a whole range of hedging. One of the things we just talked about with beta weighting-
Phil Newton: Might this be ?
Sean Donahoe: There you go.
Phil Newton: We couldn't go an episode without some randomly stupid comments.
Sean Donahoe: Abso-bloody-lutely, it would not be Phil if it wasn't.
Phil Newton: It would not be cricket, old bean.
Sean Donahoe: Abso-damn-lutely. So, okay, let's take the S&P 500 ETF SPY. Now, this is basically a trust which replicates the S&P 500, it's the way that I like to look at it. Rather than hedge with a futures contract, you could basically take your portfolio risk and divide it by the current price of the SPY. If you had, say, you had $20,000 of beta risk measured in your portfolio, measured against the S&P 500, you would need 20K divided by what it's currently trading, which is about $265, which would be shorting around 76 shares of the SPY to offset that beta weighted risk. It's a lot more cost effective approach than, again, shorting large futures contracts. Andrew, and I'm pointing at Andrew here so he can get his talking points out, what would you say, sir?
Andrew Page: Yeah, I would definitely agree with that. Those large futures contracts, unless you have a very massive portfolio, it's really not accessible to the average trader. There are some exceptions where you can use options to reduce the delta of the hedge, but that becomes very expensive and very time consuming quickly, as the option prices move, the delta moves, so you have to continuously rebalance your hedge, which can become quite costly. Another factor to consider is that those futures contracts and options have expirations, so if you were looking for a longer term hedge, unless you were buying some leaps-
Sean Donahoe: You're on the clock here.
Andrew Page: ... you're going to be SOL. If you want to hedge for a couple years, you're going to have to roll over a couple times and that roll over risk can cost you a lot of money in slippage.
Sean Donahoe: Yeah.
Andrew Page: You'll see in a normal market is in contango, contracts that are further out are generally more expensive. So, buying SPY shares, which don't have an expiration, is a really cost effective way to hedge your portfolio, or gain exposure to the broad market.
Phil Newton: Again, great for the smaller accounts, which is what you pretty much highlight in there. Again, I suppose what we ended up highlighting here is that you've got various levels of involvement. If you feel the need to hedge, then you don't have to kind of default to, "I've got to go for the futures." You can find something that is relevant to your current situation, I think that was the big takeaway I heard you say there, Andrew.
Andrew Page: Definitely.
Sean Donahoe: Awesome. Now, here's the other thing you can do with ETFs. This is where I, if I'm hedging, this is kind of where I play because I find this a much more efficient way to do this. We'll do sector hedging, as well. Now, another way, as I said, to hedge is to look at a sector ETF to hedge against individual stock positions. Like I said, I love ETFs, when I do have to hedge, this is, like I said, this is my playground, but say you were long Apple and I wanted to hedge, maybe I've got a lot of involvement with Apple, but in the short term, I'm thinking there might be a new announcement of an iPhone that I think is going to be basically lesser than, say, Samsung, and it's going to hurt them. Or, maybe-
Phil Newton: You're worried about an adverse reaction.
Sean Donahoe: Yeah. Let's use a perfect example of Facebook. Facebook had all the Cambridge Analytica news, and hype, and stupidity, and-
Phil Newton: You're worried about what's going to be said in this announcement, news, could be said, slipped out, someone could tweet something about something that's not really relevant, but everyone panics.
Sean Donahoe: Yeah, exactly.
Phil Newton: Uncertainty around Facebook, great example.
Sean Donahoe: Yeah. You've got a large position and you're like, "Uh, you know what? I want to short term hedge this, so maybe I'll short the NASDAQ or I'll short," which is again, the tech sector ETF, or the XLK, which is the technology spider ETF. I can have some short term hedging against my larger position, just in case. That's really what this is, it allows you to do a just in case scenario, does cost because you're obviously putting more capital into a market to create that hedge position, but it allows you to kind of just say, "Okay, we can weather this storm a little bit, if there is a storm. If there's not and nothing matters, then okay, get rid of your hedge." What do you guys think about that? A sector hedging, rather than, say, the beta hedge we were just talking about. I'll go with Phil this time.
Phil Newton: Yeah, it makes perfect sense. Again, it comes back to what's the reason that you're using it? If you're just worried about losing paper profits, what was your position? That would always be what I would suggest because there's something else that's bothering you, emotional reaction, if there's no justified reason. So, what you very clearly said is, there's a genuine concern for an adverse reaction because of what's going on, in this case the example is Facebook because hey, there's a lot of uncertainty going on. Which I might say that he's coping well with the interrogation. Anyway, it's justified, so yeah, using a sector ETF type hedge makes perfect sense because you're worried about it and you can do a full hedge and beta weight it, as you were suggesting earlier, or maybe you just do a partial hedge, would be one way that you could adapt the strategy. You don't want to cover all the downside risk, you just want to take the edge off the volatility, the yo-yo price behavior, because long term, maybe it's a good stock, unless it does something in the short term, that might be what you're going to hedge against. Maybe it's a partial hedge using an ETF or the sector ETF.
Sean Donahoe: Absolutely. Andrew, what do you think, sir?
Andrew Page: Yeah, I think that hits the nail on the head. The closer and the tighter you can get your hedge, the more effective it's going to be. You have a bunch of Apple shares and you're buying SPY puts to protect it, it's not going to be that effective, but a sector ETF is more effective. Then eventually, you get down to just buying options or selling the position as the most effective hedge. Yeah, I agree that using these sector ETFs is a pretty smart move, especially if you own three or four tech companies, not a bad way to go to look into that.
Sean Donahoe: Absolutely. Again, a lot of my knowledge and background in the tech sector, that is where I tend to have a lot of heavy tech stuff in my portfolio. Again, this is why I'm saying, and I was mentioning, that I use this if I do have to place at least a little bit of risk mitigation on long investment positions, this is kind of where I'll play is I'll do a little bit of sector hedging as we're calling it here. Now, the flip side of this, guys, is inverse ETFs. Now, we've all seen and talked about some recent horror stories, but let's dive into the theory first here. There are inverse ETFs and ETN, exchange traded notes, that are basically negative correlation ETFs. For example, they allow you to buy downside protection at an index. If the, say, this example, SPX goes down, then SH, the shares short S&P 500 goes up. You can take a long position in an inverse ETF rather than shorting to offset any risk in that regard. But, we all know the horror stories of recent times, so I guess, Phil, I'll let you take this one first. What say you, sir?
Phil Newton: Again, why would you use an inverse ETF versus a regular ETF is the question that comes to my mind. Again, it comes back to, what's your purpose, why you're doing this? In fairness, I always take it for granted that I'll be bullish and bearish, long and short, I'm quite happy to play both sides of the market, but for whatever reason, not everyone is happy to play both sides of the markets. They might have an ethical hurdle about not being bearish or shorting the markets. An inverse ETF allows someone to be bullish. If you've only got a bullish portfolio, they can still and be bullish on the inverse ETF, and it satisfies their hedge, as it were, but without having the moral dilemma of being short because the inverse ETF, while is technically a short position, you're morally and ethically bullish on that position, if that makes sense. That might be a reason why I would see it because again, lots of reason why people don't short and think hedging is the devil incarnate. This is a way around that from that moral and ethical viewpoint. I'm not saying I agree with it, but that would be the most obvious reason why I think that an inverse ETF is a good idea, or the why's I'd be thinking about, might as well just the regular ETF.
Sean Donahoe: There you go. Now, Andrew, we talked about this in the a little while ago with the volatility crisis.
Andrew Page: Yeah.
Sean Donahoe: Tell us what was going on there, remind everyone what was going on there, and why that was a big risk mistake for a lot of people.
Andrew Page: Well, we'll get into that in a second. Basically, let's take this example here where you've got your S&P 500 and then an inverse ETF, which basically moves up when the S&P 500 goes down. A real good reason to put a trade on in these inverse ETFs is if you want to short something, but you don't want to take on that unlimited risk or borrowing costs, or holding, over a long period of time.
Sean Donahoe: Yeah.
Andrew Page: The worst you'd lose is 100%, whereas if you short the S&P 500 outright, your max on loss is unlimited and you will have to pay borrowing costs to your broker, which can be quite steep-
Sean Donahoe: Yes.
Andrew Page: ... to borrow those shares. Now, what happens specifically in the volatility index, basically, the volatility index moves up when the S&P 500 moves down. An inverse ETF generally moves up along with the S&P 500, but volatility, as its name would imply, is really volatile.
Sean Donahoe: The clue is in the name, as we say a lot.
Andrew Page: Exactly.
Phil Newton: It's just for fun.
Andrew Page: Yeah. When people piled into these inverse volatility ETFs, it became a very crowded trade, and there's a reason for that, volatility always falls in the long run. It will spike up during an event, it might stay elevated for a while, but it always comes back down. It's an "easy way" to make money, but the problem is, it carries some serious risks and that came full circle a couple months ago as some of these inverse ETFs went down 100% one day because the volatility index went up over 100%. That's a real risk. That's, I wouldn't say common, for most ETFs-
Phil Newton: But the isolated instance, in this particular case, I feel.
Andrew Page: Yeah. It's important to realize what you're investing in. There were some ETFs, which is an electronically traded fund, that survived that tumultuous period, but ETNs, which are exchange traded notes, are a completely different beast, they're debt instruments created by a bank. Generally, they have an option to be recalled at any time and it's usually at the worst possible time for you.
Sean Donahoe: Yes. It's not in your favor, yes.
Andrew Page: Which is exactly what happened to XIV, it went down almost 85% in a day, and then Credit Suisse is like, "Okay, we're done, we're closing it, it's over."
Phil Newton: The fun is over, people.
Andrew Page: Yeah. Whereas I think that SVXY, which is an ETF, it went down a ton, but I think it'll eventually recover, maybe in 20 years, but it -
Phil Newton: Don't hold back.
Andrew Page: You could average down that position, you could buy more at the bottom, and I think that, again, volatility's eventually going to go back down, so that share price will rise. You have a real chance to break even, given some patience and some more speculative buying, but XIV, it's over.
Sean Donahoe: Yeah.
Andrew Page: Lost it all.
Sean Donahoe: They picked up their notes and we're going home, that's it.
Andrew Page: Exactly.
Sean Donahoe: Yeah. A lot of people were left holding the bag on that one, that was very ... Now, again, that also then dramatically impacted the volatility, the VIX, the main volatility index, and you could see the huge spike-
Andrew Page: Yeah, it was like a vicious cycle, it kept going higher and higher because of that.
Sean Donahoe: That really then caused a lot of panic in everyone else and all hell broke loose. That's different ways that you can use ETFs, ladies and gentleman, for hedging, but let's get on to our favorite topic, which is options. Now, to me, this is the most common way that we look to hedge positions, but you have to know what you're doing. As with any hedging strategy, you have to have knowledge about what you're doing, and as Phil mentioned a couple of times, your reasons for hedging in the first place.
What we're going to do here is look at a few different ways to use options to hedge positions. The first one, the most obvious one, is selling covered calls. Basically, you're selling a call position against the long position you might have on a stock or security. Now, let's go with Andrew on this one. Andrew, what's your thoughts in regards to selling covered calls?
Andrew Page: Selling covered calls, it's not a efficient hedge against a loss of share price, like if share price depreciates, this isn't going to protect you against that loss, but it is a really great way to generate passive income. You sell some out of the money calls on a position that you own, you're risk defined if the stock goes up because as the stock moves up, to your point, your call is only going to lose a certain amount, and so you're basically in lockstep, and you get to collect that premium that you received at the beginning.
So, selling a little bit out of the money, or deep out of the money calls, depending on where you think these stock might end up in a given timeframe, really great way to generate passive income. Especially if you're doing it on positions that produce dividends, as most people who own those stocks aren't really worried about where the share price goes, they're more worried about how big the dividend is going to be each quarter.
Sean Donahoe: Yeah.
Phil Newton: I think it's good for those slow, lazy stocks, a great strategy for certainly a stock that's, I suppose, a blue chip, like you were just describing. You're talking about big dividends, it's a slow mover, and where it fails, as you rightly said, Andrew, is if you get a big spike in the movements, then you've got to have your stock called away by the option if it expires in the money. Yeah, it's a good strategy. I would agree with you though that it's not ... I don't consider it a hedge in the true sense, but it's a good way to ... I always compare it to, it's like renting the spare room out.
Sean Donahoe: Yeah.
Phil Newton: You've got this house, but you don't use all the rooms, you might not use the garage, maybe you've got a basement that you're not using, maybe you rent it out and there's a possibility, because of the way that the contract's arranged, that you might have to sell it to them at some point in the future. In the meantime, you can keep collecting that rent.
Sean Donahoe: It's rent to buy, that's basically the way I see it in terms of real estate, it really is. It is a strategy that a lot of people use to keep collecting those premiums and then they roll them, move them, and everything else, and just keep on moving it to collect those premiums, with a little bit of security.
Phil Newton: You'll benefit from a slow movement in the stock price with this strategy.
Sean Donahoe: Yeah.
Phil Newton: Whereas what we want, we prefer, we're using it as an alternative, we're buying options typically as an alternative to the stock, so we would prefer the fast movement in our scenario, most of the time.
Sean Donahoe: Absolutely. Which kind of leads us on to buying puts. If you're long a stock or a security, then buying a put protection is essentially taking out a little bit of insurance against your holdings. So, Phil, what's your thoughts on this one?
Phil Newton: That's exactly it, it's like buying insurance. You've got stock, a couple of reasons why you might do it, you might initially buy stock and then sell a put at a certain point below that purchase price, and that locks in a fixed loss, without having to worry about an actual stock loss. This is kind of like the big trap for most retail traders, is that they put a physical stop loss in the market, a small swing in the price will get them out the position, but they probably don't need to be out the position because long term, they've got a viewpoint that's not yet been fulfilled. A better way of doing it than using the stop loss would be to buy a put instead of using a stop loss. The idea is if you buy a put, because you own the stock, should the stock move down and your trade idea not be right, you can give the stock away at the higher price, or you can put it away. That's the idea.
Conversely, if you're right, if you're worried about those paper profits that we were ragging on investor earlier, you can buy a put similarly to lock profits in. What you're hoping for in that scenario is the stock's risen, you're worried about a downward movement in the stock price, again, Facebook might be an example of this, you're worried about Zuckerberg dropping the ball and not managing the interrogation that he's going through. So you buy some puts to protect your position or lock in profits, and should Facebook share price drop 50%, you've locked in your profits. If the stock price does rally and recover in the short term, then you're collecting some premium anyway, which goes in your pocket. It's a good all around, very versatile strategy that would be, in my mind, a good hedge in those scenarios.
Sean Donahoe: Absolutely. Now, Andrew, what do you think about buying puts against long positions?
Andrew Page: I think buying puts against long positions is a very effective way to protect against large, adverse movements, but buying puts is a very expensive insurance policy. If the stock doesn't move, either in your favor or against you, it just stays flat, that's going to cost you a lot because you had to put up all that premium to buy those puts in the first place. It's important to structure the options hedge that you're creating correctly, and understand that there's always a trade off. If you want less risk, it's going to cost you.
Sean Donahoe: Well, that's exactly it.
Phil Newton: You're going to pay for it somewhere. I suppose just to reinforce what you were saying there, Andrew, it comes back to purpose. Doing for the sake of doing it because you can is not the reason to do it.
Sean Donahoe: Yes.
Andrew Page: Yeah.
Phil Newton: If you've got a genuine ... Again, the Facebook, funky going on in the news that has you concerned and you're worried about the downside risk. That would be a great time to do this, but doing it just for the sake of doing it, not a good time, there's other things that you can do.
Andrew Page: Definitely.
Sean Donahoe: Definitely. Okay, cool. This brings us on to the last one here that I would talk about, which is collaring. Now, again, a lot of people aren't familiar with this, but it's basically doing both of those strategies that we just talked about, selling covered calls and buying puts, at the same time. This basically allows you to lock in the minimum and maximum potential sale price of the equity. It kind of puts a wrapper around your position on both sides. Now, Andrew, what do you think about collaring in this regard?
Andrew Page: Well, I think collaring, it's a really great strategy and it's actually how you would want to short box a stock now and protect against some tax liability, and that's completely legal, there's no problems with that, at all. It's going to cost you a little bit of money, as opposed to short boxing, which you're basically getting out of the position since you're reducing your risk to zero by shorting one for one. That's basically a perfect hedge, which is difficult to do, but with options, especially if you're trying to produce like a tight collar in this instance. Yeah, a really effective strategy if you've reached your profit target, but you can't sell right now for one reason or another, generally it's a tax reason, you want to avoid getting that short term tax. Put on a collar, that's easy, that lock's going to lock your profit in. You'll probably lose a little bit if it moves against you, or make a little bit more if it moves up, but generally, you can make the collars pretty tight where it's going to be only a five percent difference really.
Sean Donahoe: Yeah. You've nailed it on the head because it is a great way to lock in that profit without having to worry about the tax mitigation at that point. It is, like you said, it is perfectly legal and it's a strategy a lot do in their long term portfolios, all that.
Phil Newton: I think that's one of those strategies, it's not sexy, it's not got one of those fancy names.
Sean Donahoe: No.
Phil Newton: It always gets forgotten about. Yeah, that's exactly what I was trying to say. Yeah.
Sean Donahoe: Perfect, perfect, perfect. Well, again, like we said guys, and we'll kind of wrap this up, these are just some quick ways to hedge positions. Personally, a lot of our way of trading, as we said, doesn't actually require any of these techniques in the first place, unless we are dealing with very large portfolio positions. We're primarily options traders, myself and Phil are primarily options traders. These are strategies that you can use to create hedges if you really need to, but you've got to understand what the purpose is. Like I said, a lot of our strategies have direct risk mitigation built right in, and we manage our portfolio and positional risk with specific strategies that allow us to, as I said, mitigate that downside risk and maximize the upside potential. Now, any last words, gentlemen, before we rock on and we kind of wrap it out?
Phil Newton: Yeah. I think just a final thought, which we hadn't really discussed when we were thrashing out the topics for this week. If you're worried about directional risk, then there are alternative strategies like directionally mutual strategies, alterative strategies. Pairs trading, for example, on the futures market, which we didn't actually cover this, this time, but it's a different strategy, not technically a hedge, so I understand why we didn't cover it. There's alternative strategies to exposing yourself to a directional risk. You can stay directionally neutral, you can be a seller of options, which has less of a directional impact, you're less reliant on the direction, or you could be completely directionally neutral and trade some type of futures spread, which is like a calendar type spread, which is an alternative. What I'm trying to highlight is that if you're worried about the direction and then you can trade directionally neutral, and avoid the need to be hedging, which is what we were suggesting earlier, as well.
Sean Donahoe: Andrew, do you want to talk about futures spreads and calendar spreads? I know that's kind of your area of expertise. Do you want to talk about that?
Andrew Page: We'll talk about it briefly here. I guess it could be considered a hedge, just because your risk is reduced greatly as compared to trading an outright futures contract, but your risks differ, they completely change when you put on a spread trade between a corn expiring May and a corn expiring June. Basically, you are no longer trading corn versus the dollar, you are trading the supply and demand of corn. Which, again, is a completely different risk. I hesitate to call it an actual hedge, I think it's just a completely different-
Phil Newton: It's an alternative. I think that's what we're suggesting. It's not hedging in the true sense, but it's certainly an alternative to having-
Sean Donahoe: It's a risk mitigator, yeah.
Andrew Page: Yeah, it's definitely less risky trading outright contract. Your moves are going to be much lower, generally speaking, and the margin costs less. Every once in a while, you'll get some kind of event specific to that commodity, such as a blight or something, which could cause the spreads to go in opposite directions, and that could widen your losses worse than just an outright contract, but those events are much more ... They're a lot rarer than, say, something happening with the dollar that affects the corn market which you weren't paying attention to.
Sean Donahoe: Yeah, absolutely. There you go ladies and gentleman, I think we got a good basis of understanding of hedging here. We've got some strategies, but like I said, a lot of the ways that we trade our strategies, we don't need to worry about that. If you'd like to find out more about that, check out the on demand trading on our site,, and we kind of go into that in a lot more detail and kind of give you some ideas there.
So, with that being said, let's move on.
Automated: Now, it's time for the Rebel Trader tip of the week. Brought to you by Ready to take your trading game to the next level? Discover where smarter traders come to get coached by the best and learning to trade just got way easier. Trade Canyon, smarter traders live here.
Sean Donahoe: So, the Rebel Trader tip of the week, and we kind of talked about this in the main show, kind of skirted around this, or the main topic of today's show, should I say, but basically define your risk and know your risk. As you can see in today's show, we were talking about some heavy strategies and we kind of got down in the weeds with this one a little bit. We get asked about hedging all the time and we wanted to cover a lot of different ways to do it that are common with professional traders and high end retail traders. However, these strategies add layers of complexity across the board. If you know your risk tolerance and apply strategies that alow you to predefine your risk, that you can then shape your trading around that risk tolerance and those strategies, then you're going to be in far better stead. Too many people trade without knowing where their thresholds really are, and then they get bitten hard.
Let's start, Phil, what do you say about that and about define your risk and know your risk tolerance?
Phil Newton: It's always the same thing for me, reduce your position size. If you're worried about something, that's why you're going to hedge. So, how do I remove that need to hedge, that's usually what's on my mind. The way that I try and combat the necessity to hedge, which was the main show, is to understand the risk, what's acceptable, what's comfortable for me. I want to be able to sleep at night, so I need to reduce my position size, always that the first thing that I'm doing. The great thing with the strategies that we use, we can really get down to, with small accounts, you can trade with 30, $50 if that's what you want, if that's the comfortable level for you, if that's the point where you can still sleep at night, then do it.
If you've got a good strategy, which is the second point that I always like, is have a good strategy. We refer to it as a positive expectancy strategy. That's the fancy way of saying we expect to make money, and we've tested it, and proven it, and made sure that, hey, we're expecting to do well on average. If you've got reduced position size, you've got a reasonable expectation from a strategy.
The third and final way that I want to manage risk is to put more trades on it. Now, this really sounds counterintuitive, but placing more trades allows me to reduce the risk because I firmly believe that the way to combat the risk and the fear of the losing position, is to put the next trade on, because I don't know which one is going to be the winner. I truly do not know which one's going to work out, but I do know that on average, 65% of the time, they're going to work out. So, I'm happy with that, and to be able to do points two and three, it all starts with defining that risk, point number one, which is reduce your position size down to that point where it's acceptable.
I was just going to say, that's all I've got to say on that.
Sean Donahoe: Perfect. Well, in that case, Mr. Andrew Paige.
Andrew Page: Are you sure, Phil? Are you sure?
Phil Newton: I'm quite certain. I think I managed to cover all the bases. I've actually given that a lot of thought about risk and defining it, and all the things that you can do, and they were the three categories that I came up with recently, with kind of like a catchall, but certainly risk.
Sean Donahoe: Perfect. Andrew, what's your thoughts?
Andrew Page: Yeah. To add onto that, hedging, it's just such a broad term. Even something as simple as you have those covered calls, or you buy and sell an option like a vertical spread, you think a stock might move five dollars, but not 10. Well, why not collect premium out at like seven or something, and reduce your cost basis, that is a hedge. You've given up potential profit and you've reduced your potential loss.
Sean Donahoe: That's exactly it. So, there you go, ladies and gentlemen, Rebel Trader tip of the week, know your risk, define your risk, and where your tolerances actually are.
Automated: If you've got questions, they've got answers. Sean and Phil dive into the virtual mailbag for this week's Rebel Traders quick fire round.
Sean Donahoe: Okay, so diving into the Rebel Trader mailbag here, I've got a question for you here, Phil, from our loving and adoring fans. "Why do people always compare the stock market and stock trading to gambling?" Now, we did an entire show about this a little while ago, but let's just give the two center here of why, and then-
Phil Newton: Well, to be fair, Sean, I was just going to bat it right back at you and say, why do you always compare stock trading to gambling?
Sean Donahoe: Burn. Sick burn, all right. Geez.
Phil Newton: Out of the three of us ...
Sean Donahoe: Yes. Well, the reason being is, I was going to be a professional gambler, it's a very easy comparison. Even like Ray Dalio, who in his book Principles, and he does this when he's speaking about it, he calls his trades bets. Really, it is, you're risking a certain amount to make a certain amount in return, so there is a very easy comparison there. For the great part of it, a trade is a bet, you're betting on the value of an equity or security changing, and then tapping that returns. You're putting down a little bit of money with the expectancy of a return on that, but we do it with slightly more skill than just rolling the dice and hoping for the best, and leaving it to chance.
A lot of gambling is luck based and chance based, there is mathematics involved across the board, obviously, it's usually in the statistical advantage of the house, even if you can push the edge in your favor, like with counting cards and blackjack, at the end of the day, even if you have that advantage, you have to have a much bigger bankroll than a casino, which you likely don't. You can have a downturn where the cards are going against you and no matter what you're doing, just that element of chance basically takes you to the cleaners. That is gambling, although there are comparisons and parallels, but yeah, sometimes I make those comparisons because it's easy for me because of my background of wanting to be a professional gambler, or professional blackjack player, to be more direct.
Phil Newton: I suppose in fairness, you're drawing on personal experience.
Sean Donahoe: Yeah.
Phil Newton: I think broadly speaking, most people compare it to gambling probably because they've got a misconception.
Sean Donahoe: Yeah, like Wall Street is a big casino, that's the public reputation.
Phil Newton: Yeah. In fairness, it is an easy comparison to make, because for most people, the stock market is a mystery. Most people, while they might never have been to Vegas and played tables, as it were, they're at least familiar with what goes on there and how it works, so it's usually an easy layman's comparison to make to what you're doing at the stock market. As you rightly said, you're placing a small nominal bet that you hope that if you're right, you'll profit from. If you're wrong, in a perfect world, you would lose a small amount. The reality is, it doesn't quite work out that way for most new people. That's the thing.
Sean Donahoe: Well, here's the thing, there's a big difference between gambling in a casino, if you're gambling, you have no idea about, for the most part, what you're doing and you're leaving it to chance. Even as a blackjack player, which is what I was doing-
Phil Newton:
Sean Donahoe: ... I treat it like a business and I don't do the ones that are sucker bets, so to speak, I play the ones where I can treat it like a business and I approach trading the same way. One thing we advocate for a lot is, "Okay, do that -"
Phil Newton: Sean, that I mentioned earlier, you've got a strategy and you're playing on a game that you're familiar with.
Sean Donahoe: Abso-damn-lutely. Yeah, that's basically, I would say, that one, perfectly good. Okay, so what else is in the mailbag there, Phil?
Phil Newton: Well, I've got one for you, Sean. I've got one for, Sean, it's one that's close to your heart.
Sean Donahoe: Okay.
Phil Newton: "Why hasn't a mathematical model to beat the stock market ever been found?"
Sean Donahoe: Because there's no one going to tell you if it even exists. Here's the thing. There's many different ways, if you're talking about AI here, algorithms and everything else, there are, and they're not going to tell you if they're doing very well, they're not going to tell you if they're finding an opportunity. Here's the thing though, the markets are becoming more and more efficient. Back in, like many decades ago, the markets were highly inefficient because it's all based on the amount of information that is available at any one time, and you can find inefficiencies and model off those. If you look at Warren Buffet, and Peter Lynch, Benjamin Graham, they are very much advocates of the markets not being efficient, and they find the opportunities in and around that. You can find inefficiencies everywhere and develop algorithms and mathematical models to take advantage of those. They're not going to become public. As soon as it becomes public, everyone's going to be trading it, suddenly the efficiency, or the advantage, it goes away. There's a lot of different misnomers about this and what is going on. There's a company called, or a hedge fund, called Renaissance Technologies. I don't know if you guys have heard of them, but they had a fund called the Medallion Fund, that basically has existed since '99, and had an average-
Phil Newton: , that Medallion?
Sean Donahoe: Maybe. There you go. Boom-chicka-wow-wow music, yes. They have an average of 35% annual returns after fees.
Phil Newton: Very respectable.
Sean Donahoe: Yeah, absolutely. They don't hire people with financial background, they hire mathematicians, physicists, astrophysicists, statisticians, and basically-
Phil Newton: So, the poor farm boy has not got a hope in hell, has he?
Sean Donahoe: No.
Phil Newton: I won't be putting my CV in then.
Sean Donahoe: They hire even game developers because they're looking at the different models they use in games development, and creative, out of the box thinking, to develop their strategies. There's lots of other quant funds and everything else that are looking at like convergencies. They'll find two very similar ways to position a trade, one that's overvalued, maybe one that's undervalued, and then they look for a point of getting out of those pairs trades when they converge. Basically, the expectation of that price may be in different exchanges, if they find one that's trading under its value, one trading over its value, on two different exchanges, they'll place bilateral trades there, "I'm waiting for them to return to me," and then, boom, they're out, they've capped in their profits.
There's different ways to look at it and there's many different approaches, but what you're doing is using algorithms to find inefficiencies you can take advantage of, rather than just gathering all the data that you can that's all publicly known. Whatever is out there at the speed of whatever a computer can process at, and then making a decision. Yeah, there's one like that, as well, but again, that's crystal ball gazing, we don't know what the future is and there's no real, per se, mathematical model to predict what's happening next. Now, with any accuracy.
What you can do is, you can look at history, you can look at trends, you could look at different things, or you can get there first, which is where the high frequency trading comes in. If there's a tweet by Trump, you can do kind of like a sentiment analysis on that, and if there's a big correlation between certain things and then how it affects the market every time he tweets, then maybe that's a strategy that you can tie into an algorithm. What you've got to do is you've got to execute that trade faster than everyone can process, "Oh, there's another tweet by Trump," boom, position's on. If that is a legitimate strategy, I'm not advocating that, that is a legitimate strategy, I'm using a random example, you can mathematically model that. You can use artificial intelligent machine learning to analyze these things to make decisions, but on the converse of that, you're always going to have other algorithms that have different options because at the end of the day, it's programmed by humans.
Until the point we hit the singularity where computers are more intelligent than human beings, and they can make their own decisions, and run their own analysis without any human input at all, which is coming, then again, still going to be computers that have different opinions of each other. So, mathematically modeling versus AI and machine learning, they're all intertwined, but they're also three different disciplines in regards to this, and absolutely, there are plenty of algorithms, there are plenty of funds that are using this technology to make money and do it efficiently. Will it replace humans? Honestly, I believe so, but not yet.
Anyway, rant over. I've got a question here for Andrew, "What are the best ways," kind of talking about Mr. Graham, Mr. Buffet, and Mr. Lynch, "What are the best ways to find undervalued stocks?"
Andrew Page: Okay. Well, let's start with this one, hard work, because it's a requirement for a lot of it.
Sean Donahoe: Absolutely.
Phil Newton: Best answer. Best answer today.
Andrew Page: Yes. This is the basis of fundamental analysis. I think fundamental analysis holds a lot of truth, especially for investment portfolios, but man, it is labor intensive. First off, if you don't know anything about financial accounting, you can't do it.
Sean Donahoe: Yeah.
Andrew Page: You're going to have to take a college class right off the bat, there's just no way around it. You need to be completely proficient in reading balance sheets and income statements, and understanding how that all fits together. I know-
Phil Newton: Can you just say, Andrew, that I can't just look at the P ratios and figure out which one's the best stock in today's newspaper?
Andrew Page: Yeah. I'm sorry, you can't do that.
Phil Newton: Is that what you're trying to tell me?
Andrew Page: Yeah. You could try that out, but -
Phil Newton: Oh, dear.
Andrew Page: ... it's not going to work. Basically, I have an investment portfolio for myself and I do this just ... Not in an in-depth way like some of kind of investment bank, but my strategy is, first, I read about a company, I don't know, in an article whatever. I look at it compared to its peers. So, the base level is, let's do just a sector analysis or an industry analysis, what are the PE ratios, what's its cash flow like, what are comparable ratios between the company, and where is the stock price at. Now, we can kind of get a baseline compared to its peers, how inexpensive or expensive it is. From there, you identify maybe an outlier like, why is this company so cheap? Well, let's find out. Then, that's where the work starts, balance sheet time.
You've got to go into like 10Ks on the SEC website, and look through their financial disclosures to see what is really going on with the company. Because maybe, yeah, that share price looks really attractive to its competitors, and that's because they have a massive unfunded pension liability.
Sean Donahoe: Yeah.
Andrew Page: That's really going to drag down on their profits for the next 30-40 years. It's really just difficult to go on Google Finance, look at some ratios, and be like, "Oh yeah, that's a good buy."
Sean Donahoe: Yeah.
Andrew Page: You can't do that.
Sean Donahoe: It is income statement and balance sheet time, shareholder letters for the last five years.
Andrew Page: Yeah.
Sean Donahoe: That's one thing that it is a very labor intensive process. It can be done, but-
Andrew Page: I think it's incredibly rewarding and I think it's something that people should know how to do. Especially if you're involved in any kind of business, you have to understand accounting because that is the lifeblood of the company, that's how money moves around.
Sean Donahoe: Exactly, it's money flow. Yeah.
Andrew Page: Yeah.
Phil Newton: I know I always rag on the fundamentals, but when we're talking about investing, it is vital that you look. If your time horizon is measured in years instead of ... Essentially, I'm looking one to two months in the future for my style of trading, that is nowhere close or even resembles looking for value or undervalue, this is just taking advantage of the swings in price. That stock could be a good stock, a bad stock, it could be a dead stock, it doesn't matter, you're talking very specifically about the investments, finding an undervalued stock.
Andrew Page: Definitely.
Phil Newton: Again, while I always rag on the fundamentals, when we're talking about investing, that's the first place you're going to start.
Andrew Page: Yeah. There's certain technical aspects like the 200 day moving average, 50 day moving average, those are really -
Phil Newton: That's more to do with timing, just to put it into a different context, but yeah, it's fundamentals, is this a good stock or a bad stock. Is it a good business?
Andrew Page: Yeah.
Phil Newton: Invest in this, is the management good, is the profits, are they paying dividends, all the good stuff that you're looking for, but you're trying to find that point with the timing where by looking at, for example, the 200 ... Again, I know I rag on them, but when we're talking in this context, it's a yardstick, it's a measure. When it comes down to those moving averages, that might help you with the timing to recognize, "Hey, this is on sale right now. It's still a good company, its on sale because we've had this big expansion in price, now it's back down to, say, a 200 day moving average, it's a good average price, maybe this is a good time to invest and see it push away from that moving average over the next two, three, five years," because that's what your expectant time is. It helps you with that timing and to recognize it's on sale.
Yeah, it's fundamental, fundamentally driven.
Sean Donahoe: Awesome.
Andrew Page: Yeah. You're also going to need to have a basic understanding of finance and financial equations. Again, I think the best place to learn these are college courses or online courses where you really get some hands on experience looking at balance sheets and interacting with some kind of mentor or tutor who is really skilled in these things, and knows a lot about the financial statements. So, first, if you want to start getting into finding undervalued stocks, you have to learn that. You just have to, there's no way around it. It's not a waste of time, it's really important to know. If you're a small business owner-
Sean Donahoe: It's a very good skill.
Andrew Page: Yeah, it's great. It's a great thing to know. Places like Kahn Academy have coursework on basic accounting and all that kind of stuff.
Sean Donahoe: Yeah, there you go. Perfect, perfect, perfect. Okay, that being said, let's rock on.
Automated: Don't forget, if you have a question you want to ask Sean and Phil, just go to, and your question may be featured on a future show.
Uh-oh, what's that smell? It's time to call out the Wall Street shenanigans, mainstream confusion, and outright hi-jinx and hokum of so-called experts. Yep, it's time for bullshit of the week.
Sean Donahoe: Okay, so bullshit of the week. We have a plethora of bullshit this week and I am really kind of having to pick and choose, and I don't know where to start, but I think we'll start right here because -
Phil Newton: Mind your step there, Sean. Mind your step. You're about to step in some over there.
Sean Donahoe: Abso-damn-lutely. There's a lot of it around, a lot of it around.
Phil Newton: It's like a minefield.
Sean Donahoe: It really is, cow pie minefield. I'm going to start here with Congress. Now, we're going to get left or right with this one because we're going to go straight down the middle, they're all idiots. If you have a chance to watch Zuckerberg and his foray into a five hour, under the spotlight grilling session by Congress as of yesterday, which was Tuesday, the 10th, you've determine one thing, they have no effing clue what they're talking about. They all were all on their little soapboxes. As much as I'm not a big fan of Zuckerberg directly, and I think a lot of the stuff that's been going on with Facebook is kind of bullshit, he did face his own and he stood up.
I was joking with someone about it being like Iron Man, where it's, "No, you can't have it. It's mine, you can't have it. No." There's one line where someone, I can't remember which Senator it was, said to him, "Do you think that you're better people's private information securely than the government?" He turned around and just said, "Yes." I love that and honestly-
Phil Newton: With confidence, as well. With confidence.
Sean Donahoe: And with absolute confidence. You know what? He was well prepared, he was well armed, he explained stuff that was just way over their heads, they asked stupid questions, whatever their biases were, but I've got to say, he did well. Because he did well, the stock price absolutely shot up yesterday because everyone was like, "Oh okay, cool, he didn't get nailed, he didn't get skewered. There was a couple of awkward moments, but honestly, he seriously held his own." That gave confidence back to investors to put money . The bullshit is basically-
Phil Newton: He was a confident, articulate CEO taking a grilling and giving what appeared to be, from the outside looking in, very articulate and well constructed answers.
Sean Donahoe: Yeah. It's kind of obvious what he was going to be asked, as well.
Phil Newton: Whether you like him or hate him, or you love or hate the situation, you can't deny as the head of the ship, of a publicly traded company, he held his own, which was then reflected in the confidence that then happened in the stock price.
Sean Donahoe: Absolutely. Yeah. The Senator is stupid.
Phil Newton: To Zuckerberg, I've got to take me hat off.
Andrew Page: Yeah. The questions they were asking, there were some good questions and there were some valid points made, but by and far, the Senators were completely out of touch with the business model and -
Phil Newton: In reality, at some point, just out of touch with reality.
Sean Donahoe: Yeah. Sorry, . I don't think it was a Senate hearing, it was a Congressional hearing, wasn't it?
Andrew Page: Sorry, Congressional hearing. My bad.
Sean Donahoe: Yeah. At the end of the day-
Andrew Page: Do your research. It was like trying to explain technology to someone who's never used it before.
Sean Donahoe: Yeah. I was watching it live with a friend of mine, we were watching it online, and we were talking back and forth, it was like, "That's not how that works, that's not how any of that works." Then again, honestly, one of my other companies is obviously a marketing company, we're very heavily involved with paid media and everything else, and we take full advantage of all the data that is available to us for those marketing purposes. So, for my mind, I look at a lot of what's been talked about, it's like, "That's just complete and utter hyped bullshit."
Phil had an amazing observation that we were talking about, because I was talking about this from a general perspective, but Phil said, yeah, I was comparing something else. So tell us what you were talking about, in regards to that news coverage.
Phil Newton: Well, I wasn't watching it live because I was enjoying an afternoon reading a book, my afternoon in the UK, reading a book and enjoying a glass of vino, and meal somewhere, so I wasn't watching it live is the point. What I was in this morning, as we're recording this, which is the following day after it, I was watching the abbreviated and summarized versions. I wasn't just watching one because I don't have a favorite news item, but I was just looking at all the summary clips, the three minutes here, the 30 seconds there, the five minutes here, just all the condensed versions from the plethora of news outlets out there, all vying for your attention. What was very apparent is that depending on which side of the fence, whether you were for or against the situation, depending how it was cut up, and the same questions were asked, and they were showing a different answer to a different question straight after. They were literally jumping the clips back and forth in a very manipulative way.
If you only watch one news item, again, this is the whole argument of why I don't watch the talking heads, or if I do, I want to get a broad spectrum of what's going on with a wide net to catch all the news stories, and then make up my own opinion. What was very abundantly obvious was how the media was manipulating the situation dependent on which side of the fence they were on. There was no balanced, summarized, "This was said," kind of like a summary of all the main points. They were just trying to make either one side of the fence look good or one side of the fence look foolish, and it was abundantly obvious that it was absolute bullshit.
Sean Donahoe: There you go. Yeah, it was. We got a double bullshit there, right there, all in one scenario, and I thought that was absolutely bloody classic.
Phil Newton: It was very manipulative. I only realized this after about five, 10 minutes. It didn't sound like long, but just short clips of media being watched back to back, certainly I realized, hold on a moment, hold on a moment, something's being manipulated here and it's certainly not going to be me.
Andrew Page: Yeah, that's a huge problem that the US specifically and countries around the world are going to have to face. I know in the US that these organizations are under no obligation to actually tell the truth. That, right there, and that's not a joke, they can say whatever they want, and change, and manipulate things for rating.
Phil Newton: It was absolutely massaged, completely massaged, would be the very polite way of saying it. I don't think it was an accurate or true reflection of what was going on. Although, technically, they are stating the facts of what was said as per the video clip, but they had cut it and they were jumping back and forth in such a way that it gave a narrative of either Zuckerberg looks amazing or Zuckerberg looks an absolute tool.
Sean Donahoe: Yeah.
Andrew Page: Yeah.
Sean Donahoe: Very much. That is absolutely apparent with the bias of reporting. Again, you've got to look at it from multiple angles.
Phil Newton: It is actually disgusting to watch. I don't use the word lightly, but it was offensive because it was, once again, the layperson is being hoodwinked. I think that is the true atrocity of all of this, is how people are having the media and allowing the people to manipulate, rather than just to report factually on a situation, and not make it obvious that the segments of the video that you were watching were actually different questions and different answers. They just made a whole mockery of the situation.
Sean Donahoe: Perfect answer. Okay, well, that being said, ladies and gentlemen, that's it for this week's show. Hope you enjoyed. We got on a few soapboxes here, but we've also called out a lot of good bullshit, a lot of good strategies, a lot of different ways that you can mitigate risk in your portfolios, in your individual positions, and why and when you should or should not do it.
Please remember that this show is not free, it will cost you a five star review. Just go to, and where you can subscribe and review us on your favorite way to hear the show, it helps us reach out more, our message to more traders and investors just like you.
Phil Newton: If you'd also like to connect with us on some of the social medias, you can get to us on Facebook or Twitter. Go to the same link at and you can select which if your ... To be fair, by the sounds of it, some people might never go to Facebook again, or Twitter for that matter, so maybe you don't want to connect to us on social media. Maybe you want to get to us the old fashioned way, you can send us a fax, you can pick up the phone-
Sean Donahoe: Telex, telex, we've got beepers.
Phil Newton: ... and maybe if you go down to the bottom of the website, you could actually write us a letter.
Sean Donahoe: There you go.
Phil Newton: Next week's, Sean?
Sean Donahoe: Well, we are going to be talking about the Coriolis effect. I'm talking about the curvature of the Earth, and I'm going to tie that into trading, and basically, we're going to look at what happens around the world and how it affects the economy here in a cyclical manner, and we're going to dive into that in a little bit more detail. With that said, any last words, gentlemen? I'll start with Phil.
Phil Newton: It's better to burn out than to fade away.
Sean Donahoe: Oh my God, he's going to do from Highlander, the 32 year anniversary.
Phil Newton: I'm not going to do the voice. Happy Halloween, ladies.
Sean Donahoe: Yes. I love that movie, I'm going to go watch that now. Andrew, any sensible last words?
Andrew Page: Yeah. I'll put some sense into this, just a little bit, we don't want to take away from Phil's fun too much.
Phil Newton: Madness. Absolute madness.
Andrew Page: If you're considering putting hedges on, make sure you research your risk tolerance levels and research exactly what you want to hedge, and as Phil says, why emotionally you want to hedge it. That's really important.
Sean Donahoe: Abso-damn-lutely. Okay. Well, thank you, gentlemen. Thank you, ladies and gentlemen, see you on next week's show. Take care for now.
Phil Newton: Bye for now.
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Automated: Futures, options on futures, stock and stock options trading involves a substantial degree of risk, it may not be suitable for all investors. Past performance is not necessarily indicative of future results. Trade Canyon Incorporated provides only training and educational information. If you actually understood and listened to this, then that means you are awesome. Congratulations and well done. Notice, this product may contain nuts.

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[00:00:10] Show Introduction

[02:12] Sean: Hedging is risk mitigation by placing one trade against another to give you extra protection.

[03:15] Phil: In my mind, a true hedge was always to reduce the directional risk. If your trade idea was wrong, you'd still end up being right somewhere.

[04:13] Andrew: From a futures and commodities perspective, hedging is huge. You are using a trade to protect against an adverse directional movement. Farmers do it when they're worried about falling prices. Say some guy's growing wheat, he'll short a futures contract to protect his crop value. It's really good for the farmers and consumers because they get stable food prices.

[06:36] Phil: We see swing in oil prices impact the airline industry. The airlines hedge their ticket prices on futures markets to try to stabilize the price of oil. Who's concerned about short term fluctuation? Maybe the funds, retail traders. They want to stabilize their portfolios.

[08:05] Sean: Pairing is offsetting your position with another position in a similar but different security.

[08:17] Phil: The traditional hedge.

[08:21] Sean: Find another company with similar metrics. Place a position on your target security, and then short sell the hedge target you found to create a paired hedge. I don't like this method because there's potential for more risk. There are unpredictable variables.

[12:03] Andrew: Trying to do pairs trading is quite difficult because stocks have a natural bias to the upside. When the market is rising, some of the most effective hedges are large index funds like SPY, S&P 500.

[12:52] Sean: It's important to have a lot of positions on and create a portfolio.

[13:04] Phil: When that downswing happens, the bullish stocks are not gonna be very impacted, and the bearish stocks will see that exaggeration of the downward movements.

[15:34] Sean: Our strategies allow us to have built-in mitigation. We don't, per se, need to hedge. Short boxing is a strategy that short-sells the same stock.

[17:34] Andrew: I haven't used this strategy much myself. It can be used to avoid capital gains taxes. If you sell under a year, taxes are very high. Over a year, very low.

[18:49] Phil: I've always known it as trading around the position.

[20:11] Sean: It is a short-term, hit those fluctuations as you get in or out of a position.

[20:22] Phil: The objective of short-boxing is for tax reasons, whereas what I'm doing is benefiting from the fluctuations in price to increase the bottom line profit.

[20:38] Sean: Here's an example using futures to hedge a portfolio, rather than individual positions. The term 'beta-weighting' means we are baiting one underlying against another as a comparative analysis.

[21:45] Phil: It's like putting your stocks on the metric system. Everyone's using different systems, and you're converting everything to one unit. It's all the same.

[22:44] Andrew: If the S&P 500 starts at one, that would be the comparison. If your beta-weighting is 0.3, you're moving at one third of the speed of the market.

[23:50] Phil: How can the little guy get involved? How does the poor farm boy use futures to hedge?

[24:03] Sean: You can go with e-minis.

[24:05] Andrew: With futures contracts, you don't have to put up the full value. It's generally some smaller amount called margin, which is 3-10%, maybe higher for something more volatile.

[24:22] Phil: We're not suggesting you trade leveraged margin.

[24:27] Andrew: It's a good-faith deposit.

[25:07] Sean: It's a lot of capital, even if you're doing the deposit version.

[25:48] Phil: Just because you can hedge doesn't mean you should.

[25:54] Sean: You want an imperfect hedge. If your hedge is of greater value than your portfolio, you're buying or selling risk.

[26:22] Phil: If you've got 20-40 positions, it makes sense to go to the future market and say I'm worried about an adverse move in my portfolio. You can buy a proportional or full hedge, meaning you've covered all of your portfolio.

[29:36] Sean: Let's move onto the flip side of futures hedging, which is ETFs. The S&P 500 ETF, SPY, is a trust which replicates the S&P 500. Rather than hedge with a futures contract, you could take your portfolio risk and divide it by the current price of the SPY. If you had 20k of beta risk, you would divide 20k by what it's currently trading ($265), which would be shorting about 76 shares of the SPY to offset that beta-weighted risk. It's a lot more cost effective than shorting large futures contracts.

[30:56] Andrew: With large futures contracts, unless you have a massive portfolio, it's not accessible. There are exceptions to use options to reduce the delta of the hedge. That becomes very expensive and time consuming.

[32:06] Phil: Great for smaller accounts. Various levels of involvement.

[32:34] Sean: If you were long Apple, you could hedge in the short-term in case you're worried about an announcement.

[34:34] Phil: What's the reason to hedge? If you're worried about losing profits, close your position. But using a sector hedge with Apple makes sense. Do a full or partial hedge.

[36:21] Sean: I use this if I do have to place a little bit of risk mitigation on long investments. The flip side is inverse ETFs. ETNs are negative correlation ETFs. They allow you to buy downside protection in an index.

[36:21] Sean: I use this if I do have to place a little bit of risk mitigation on long investments. The flip side is inverse ETFs. ETNs are negative correlation ETFs. They allow you to buy downside protection in an index.

[37:32] Phil: Why would you use an inverse ETF as opposed to a regular ETF? Unlike me, not everyone is happy to play both sides of the market. An inverse ETF satisfies their moral viewpoint.

[39:08] Andrew: A good reason is if you want to short something, but you don't want to take on that unlimited risk for borrowing costs for holding over a long period of time. The worst you could lose is 100%, whereas if you short S&P 500 outright, your max loss is unlimited. Volatility is an easy way to make money, but it carries serious risks.

[42:32] Sean: When this happened with XIV a couple months ago and it was shut down, a lot of people were left holding the bag. It dramatically impacted the VIX.

[42:44] Andrew: It was a vicious cycle. Kept going higher and higher.

[42:54] Sean: Now onto our favorite topic, options. The first way is selling covered calls. You're selling a call position against the long position you might have on a stock or security.

[43:37] Andrew: Selling covered calls is not an efficient hedge against a loss of share price. You sell some out of the money calls on positions you own, you're risk defined if the stock goes up. Great way to generate passive income.

[44:44] Phil: Great for blue chip stocks. Slow movers. I don't consider it a hedge in the true sense. I always compare it to renting a spare room out.

[45:31] Sean: It's rent to buy. It’s a strategy many use to keep collecting those premiums.

[45:55] Phil: We're buying options as an alternative to the stock, so we would prefer the fast movement usually.

[46:04] Sean: This leads us to buying puts, which is taking out a little protection against your holding if you're long.

[46:15] Phil: It's like buying insurance. It locks in loss without worrying about a stop loss.

[48:03] Andrew: I think buying puts against long positions is a very effective way to protect against large, adverse movements, but it's a very expensive insurance policy. If the stock doesn't move in your favor, that's going to cost a lot. You had to put up all that premium to buy in the first place.

[48:36] Phil: You got to pay for it somewhere.

[49:09] Sean: Coloring is selling covered calls and buying puts at the same time. It allows you to lock in the minimum and maximum potential sale price of the equity. It puts a wrapper around your position on both sides.

[49:31] Andrew: I think it's a great strategy. It's how you would want to short box a strategy and protect against some tax liability and it's completely legal.

[50:48] Phil: It's not sexy. It's not got a fancy name. It gets forgotten about.

[51:07] Sean: These are some ways to hedge positions. Our way of trading doesn't require any of these techniques unless we are dealing with very large portfolio positions.

[52:42] Phil: If you're worried about the direction, you can trade directionally neutral and avoid the need to hedge.

[52:58] Andrew: Your risks differ when you put on a spread trade between a corn expiring May and a corn expiring June. You are trading the supply and demand of corn.

[54:34] Sean: Check out On Demand Training on our site for more detail.

[00:54:40] Rebel Trader Tip of the Week

[54:58] Sean: The Rebel Trader Tip of the Week is define and know your risk.

[55:57] Phil: Reduce your position size. With small accounts, you can trade with $30 or $50. You can place more trades on too.

[00:58:40] Quickfire Round

[58:54] Sean: From the mailbag: Why do people always compare the stock market to gambling? We did a whole show on this.

[1:01:07] Phil: Most people have a misconception that Wall Street is a big casino.

[1:02:00] Sean: If you're gambling, you're leaving it to chance. As a blackjack player, I treat it like a business.

[1:02:40] Phil: I've got one for you: Why hasn't a mathematical model to beat the stock market ever been found?

[1:02:40] Phil: I've got one for you: Why hasn't a mathematical model to beat the stock market ever been found?

[1:02:48] Sean: Because no one's gonna tell you if it even exists. If you're talking about AI and algorithms, they exist. Will they replace humans? I believe yes. But not yet. Questions for Andrew: What are the best ways to find undervalued stocks?

[1:07:40] Andrew: Hard work. This is the basis of fundamental analysis. It is labor intensive.

[1:10:24] Phil: I always rag on the fundamentals, but when you're talking investing, it is vital. If your time horizon is years, that's the first place you're gonna start.

[1:12:13] Andrew: You're also going to need a basic understanding of finance and financial equations. It's not a waste of time.

[1:12:53] Sean: Let's rock on.

[01:12:40] Bulls**t of the Week

Resources for this Show

[1:13:23] Sean: As much as I've not a big fan of Zuckerberg directly, he did face his own. He was asked, "Do you think you're better to hold people's info securely, than the government?" And he said yes. I love that. Because he did well, Facebook's stock price shot up.

[1:15:32] Phil: It was a confident, articulate CEO taking a grilling and giving what appeared to be well-constructed answers.

[1:15:58] Sean: The senators looked stupid.

[1:16:03] Andrew: There were some good questions and valid points made, but by and large the senators were completely out of touch with the business model.

[1:16:17] Phil: And reality.

[1:16:36] Andrew: It was like trying to explain technology to someone who's never used it before.

[1:17:26] Phil: I didn't watch it live, but the day after while watching the abbreviated versions, what was apparent was the side of the fence, some questions were asked, and they were showing a different answer to a different question. It was very manipulative.

[1:19:32] Andrew: In the US, news organizations are under no obligation to actually tell the truth.

[1:20:36] Phil: The layperson is being hoodwinked. We're allowing the media to report devious information.

[1:21:00] Sean: That's it for this week's show. Please leave us a five star review at You can subscribe and review us, or connect with us on social media from the same link.

[1:22:10] Sean: Next week we're talking about the Coriolis Effect. The curvature of the earth and how it affects the economy in a cyclical manner.

[1:22:54] Andrew: If you're considering putting hedges on, research your risk tolerance levels, what you want to hedge and why.

[1:23:19] Sean: See you next week.

[1:23:24] Phil: Bye for now.

Resources & Links Mentioned in This Week's Show

3 Key Takeaways From This Show

  • Know your risk and risk tolerance, it’s essential to your trading.
  • Ask yourself, are you in a long term position that you want to hedge or is it time to just get out?
  • Make sure you are beta-weighting your portfolio against a relative index to understand your risk exposure.

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