Friday, 11 March 2011

$WDC risk managing the position

1) obviously we hedge, but what with? why? how do we calculate hedge ratios.
2) we have a stop, but of time or price? and where?
3) what position size is appropriate relative to the rest of the portfolio?
4) is there a good option trade to structure this better?

The most important thing is to be robust. Be roughly right rather than precisely wrong.

The natural hedge would be Seagate. We're betting on improving pricing in the hdd industry, shorting Seagate would remove that factor so a broad sector or index hedge is a better idea.

Calculating beta, ie the correlation between the stock and an index, has plenty of academic page space, the Raven uses his own special sauce, but it doesn't make that much of a difference.

Computer says... 1.5.

The nasdaq is a poor index to use as a hedging tool as it is very concentrated in AAPL.

We hedge to remove systematic risk, not add idiosyncratic risk, so a better choice would actually be a blend of indices, half spoo half nasdaq, looks robust enough, calculating a new beta to this... computer says..2.4raw 1.95net, the main driver of this high beta is the high volatility of WDC and relatively low volatility of the spoo. This suggests selling $0.97 of spoo and $0.97 of nasdaq for each $1 of wdc.

To be logically consistent we should have a look at the residual chart for $WDC, we at least have a history of the pnl of the trade that we are putting on rather than just looking at an outright chart, or using some rule that we don't have any feeling for.

It also allows us to at least estimate the risk in our hedged trade, as such for a $1 of wdc, we can expect daily moves of $0.04, with the worst daily move of -$0.38. These numbers are meaningless. A dollar of wdc is a dollar that could be lost. Theoretically it is possible to lose more, if the stock dropped to zero and the hedge rallied, but assuming risk of greater than $1 is over cautious and unrealistic. What it means to us is that we need to be cautious and not leverage the position, although many people would say that $1 of wdc and $1.95 of hedges is already leveraged. A reasonable stop would be a loss of 20% in price performance, and a reasonable stop in time would be 3 months.

3) Obviously this depends on what other positions are in the book, risk tolerance etc. What can be said absolutely is an upper limit on the position size, and that placing anything bigger would be a mistake. quarter Kelly betting criterion would suggest nothing greater than 5%. That is an upper bound.

4) Given that this isn't an event driven trade, ie. we are not anticipating a takeover, spinoff, rights issue, etc, then the value of using options is that they give us leverage and the ability to limit our downside. Without even looking at the vol surface, it doesn't make sense that we'd pay a dynamic hedger to take risk for us, when we actively want to take risk in the stock.

However, that might be worth a look later.

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