by Andy Tanner
How Hedging Saved Mark Cuban’s Fortune
Mark Cuban became an Internet billionaire after selling his company to Yahoo! for $5.7 billion in stock. Sounds like a fairy tale ending, right? Not long after, though, the dot-com bubble burst and the market crashed. In just five months, Yahoo!’s shares dropped 90 percent.
You can see from the chart how most of the value was wiped out. Did Mark Cuban lose all that money? No, because he had hedged the stock against such a loss. This simple act of protecting himself made him look like a genius.
Steve Kroft did an interview with Cuban on 60 Minutes where Kroft said, “He had a company worth $15 million in revenue and one year later it sold for $5.7 billion in stock.” That’s a pretty cool day. You take your $15 million company in the dot-com boom and you’re cranking out $5.7 billion in stock. Notice he didn’t sell it for cash; he sold it for stock.
Cuban laughed and said, “Boy, it’s as shocking to me now as it was then.” He was stunned it happened to him, but not so stunned that he stopped thinking. Kroft says, “More than 300 employees also became millionaires—at least on paper. But Cuban, sensing the Internet bubble was about to burst, made his shrewdest move. He began unloading his Yahoo! stock, using a hedging strategy that would lock in his profits. ‘I was covered,’ says Cuban, ‘and then some.’”
Unloading means he sold his stock, and, as you know, hedging means he insured against loss. Most likely, Cuban bought put options or some other hedge. Put options would have given him the option to sell the stock high even though the stock went right down to almost nothing. While Yahoo! was heading down, Mark Cuban would have been able to sell at the high prices of the past.
And notice the language, “I was covered,” he says, “and then some.” So he was insured and, apparently, according to him, for more than the stock was worth. Can you insure your home for more than it’s worth? Definitely, if you want to pay the premium. From his words, it appears that Cuban was over-insured and he actually made money on Yahoo!’s downward spiral.
Remember, hedging is just buying insurance on your investment. When you have insurance, you can look like a genius no matter what happens. If Yahoo!’s price had gone up, Cuban would have been a genius for selling his company for stock. But when Yahoo! went down, he looked like a genius for planning ahead and having a hedge.
This is a great example of how good risk management made someone look smart, but I think it’s the opposite. Mark Cuban would have been a fool not to hedge that stock. Think of how many people were financially punished during market crashes without any kind of insurance on their investments. Markets can burn to the ground just like houses. If you’re shrewd, you have insurance. That doesn’t take genius; it’s just common sense.
For the investor looking to generate cash flow and protect assets, buying options is an excellent tool. It gives us very specific control in environments that buy-and-hold investing isn’t able to offer. Plus, it can serve as insurance for virtually any stock-investing scenario.
Correlating Assets
Some people think they are safe because they have many different stocks and mutual funds. As you look at your charts, with your advisors, you might find something that you never expected: Many mutual fund charts are nearly identical copies of each other. This can be a great lesson about diversification. Some folks think they are safe through buying a number of different funds. In other words, if these funds are all correlated to the overall market they often have the same movement.
Look at the charts above to see correlation in action. Some people believe they are spreading their risk around, but often they find that their mutual fund is not much different than if they had been investing in these individual indexes. As you can see, though, the indexes essentially follow each other because they are the mirrors of overall market behavior.
The trades might seem different because they are at different price levels, and because there will be different strikes and different premiums. But they’re all correlated together and follow the same movement. They go up together, and they go down together. The investor who unwittingly invests in correlating assets is very exposed.
Correlating assets don’t offer us an opportunity to hedge against each other. This is why our discussion of systemic risk versus non-systemic risk is so important. If you are diversified across correlating assets, then you are very much exposed to systemic risk!
Inverse Correlating Assets
Now let’s look at two new charts: the S&P 100 and the VXX. The VXX is a short-term measure of the VIX, the volatility index. Notice this inverse correlation on the charts. You can see that these charts move directly opposite of each other. When the S&P is up, the VXX is down. And when the S&P falls, the VXX rises. This is an obvious example of two inverse-correlating assets. Before investing in either, we would need to do more research. But seeing them in this sharp contrast helps us understand this non-correlating concept.
I would never buy the VXX as a long position any more than I would hope to make money on my car insurance. Some investors simply use it, sometimes, as investment insurance. Long ago I had positions in the S&P when the market began falling apart. My analysis had told me that the market was likely to go sideways, but I decided to protect myself in case things became more unstable. I knew that the VXX was negatively correlated with the S&P, so I decided to use the VXX as a hedge.
Here’s what happened: When the S&P dropped, I lost some money. But my hedge in the VXX soared and earned thousands of dollars for me. The S&P fell 20 percent, but the VXX doubled. In that situation, I was able to insure against risk and also earned a good profit by using a non-correlated asset against my main investment.
Now look at these two pairs. They are exact mirrors of each other. On the upper left is the Dow Jones Industrial Average (DIA), called diamonds for short. Below that is the DOG, which is the inverse of the DJIA, called the dog.
On the right is the Dow Jones Financial Sector Index Fund (IYF) and the inverse correlation below it is the Direxion Daily Financial Bear 3X Shares (FAZ).
Better yet, you can buy an inexpensive call on the FAZ for even greater leverage. If the IYF tanks, you know the FAZ will go through the roof and you have massive leverage with your call option.
In my own investing, I continually use non-correlating assets to manage my risk. Entering trades into non-correlating assets gives you one level of risk management. One asset goes down, but the other asset goes up. You can then add a second level of risk management with protective options on your trades.
Buying Investments in Pairs
When people purchase a home it’s almost never an isolated purchase. They pair the home with an insurance policy. To buy a home without fire insurance is foolish. Even though the chance of fire might be small, it is still out of the owner’s control, and the chances of total devastation are too great. So it makes sense to have a hedge to protect anything of value. That is something almost everyone can relate to. Yet in the stock market, very few people use hedges. Most folks buy the primary investment without the secondary purchase for protection.
While most people see it as common practice to protect the equity in their home with insurance, almost nobody thinks about hedging their 401(k) or IRA. Yet which is more likely to burn down in the next five years?
Position Sizing
Casinos are smart. They make a lot of money. But they do this by controlling risk. And there’s much we can learn from how they go about controlling risk. Here are two keys to consider.
•They strictly limit the amount they can lose in a single bet (table limits)
•They win more often than they lose (mathematical odds)
One thing they need to watch out for is big bets. Imagine you’re in a game of blackjack and a new player comes to the table with some serious cash. He drops millions of dollars down on the table, gets one lucky hand, and walks away…wiping the casino out.
The casino just can’t allow that. They have to put limits on what they can lose, so t
hey have to limit what their guests can do. Casinos make gamblers spread their money out over smaller bets and over a period of time (and they have a ton of clever ways to get gamblers to do just that) with table limits. That way, the casino allows the mathematical odds to work in their favor. That is why every casino game has a table limit that limits the size of each bet. The casinos know they are going to make money, because they limit how much they can lose in each hand and the math takes care of the rest.
Table limits also help them manage the risk they face with gamblers who try a strategy of doubling down. Let’s say the gambler places a bet and loses $5. He places a bet of $10 next time and if he wins he gets his $5 back plus more. If he loses, then he is down $15. A win on a $30 bet, and he gets back his $15 plus more. So these guys just keep doubling down, $100, $500, $1,000, $2,000. As long as they keep betting bigger and bigger, sooner or later they’ll win and get back everything they’ve lost, and more—unless there is a table limit.
You and I can use the same strategy to limit how much of our total account is at risk in any one trade. This is called position sizing. If you decide that you do not want to risk any more than 1% of you account in any one trade, then look at the risk/reward ratio we studied earlier and adjust the number of shares you trade accordingly.
The Power of Probabilities
In reality, the casino’s games of chance have more to do with math than chance. In reality, casinos leave nothing to chance. A good example is what they do with roulette, a game of win-loss percentage. With 18 red spaces, 18 black spaces, and two green spaces, the casino has the advantage.
•A bet on black, and the player has 18 chances to win and 20 chances to lose
•A bet on red, and the player has 18 chances to win and 20 chances to lose
•A bet on green, and the player has two chances to win and 36 chances to lose
Even with this clear advantage, the casino will lose some bets here and there. But they will always win far more than they lose. Now combine that with a table limit. They closely analyze and control these numbers to give them an advantage—and for the casino that means earnings.
So why don’t you do the same with each trade? Why don’t you set a limit? Why don’t you create your own positive win-loss percentage?
The answer is you can do all of those things. How do you get a win-loss percentage to increase? By becoming proficient in fundamental analysis, technical analysis, and continued education. Learn the charts. Trade with the trends. Learn to see what’s most likely. Place trades that have a high probability of paying off.
How do you limit losses? The stock market equivalent of a table limit is called position size.
Suppose you have an account of $100,000 and you determine that your risk tolerance is 1 percent. It could be 2 percent or 0.5 percent, but for now we’ll stick with 1 percent. So the risk in a trade as far as your stop loss is concerned is $1,000, which is 1 percent of your total account.
You want to enter a long position at $39 and put in a stop-loss exit at $37. That means you could lose $2 in this trade. Under your position-size rule, the most you are prepared to risk is $1,000. So the largest position size you can take is 500 shares. This doesn’t mean you have to buy 500 shares, but it does mean you aren’t buying more than 500 shares. With this limit, if you must exit the position at your exit point of $37 you won’t lose more than $1,000. So if it goes against you and you lose it, you still have $99,000. Just as a table limit keeps the casino in business, your position size allows you to trade another day.
If, on the other hand, you hit your target of $45, you’ll have made $3,000. This is more than survival; this is prosperity.
So, you do the fundamentals, you do the technicals, and you spread the trades around non-correlated assets. For the sake of argument, let’s say that with your 10 trades, maybe you’ll get a 50:50 win/loss ratio. Do the math. Five trades that earn you $3,000 each, and five trades that lose you $1,000 each.
That’s an over-simplification, but it sums up the basic idea. With education and experience you will improve your percentage of winners to losers. You will limit your position size so that you are only risking a minimal percentage of your account in any one trade.
The more trades you do—and the higher the percentage of winners to losers and the greater your reward to risk ratio—the less you stand to lose.
The Risk Management Toolbox
Take a moment and think about how you have managed risk in the past as compared to what you have read in this chapter. Review this basic risk management toolbox. You have seen how, by setting a target, you can calculate the reward you are aiming for and decide how much risk you are prepared to take to get that reward.
We have introduced the idea of placing stop loss orders so that your exit order will be triggered if the trade turns against you, thus limiting your losses.
We have looked at how you can use protective options to insure against loss, just as you insure your house against fire. You hope it doesn’t happen but, if it does, you’re covered.
You have seen how to pick non-correlating assets to manage the risk. If one of your trades tanks, all the others won’t necessarily tank with it.
We have looked at position sizing, deciding on the size of your trade based on the potential loss and what percentage of your account you are prepared to risk in a single trade.
And what has this all been about? It has been about controlling the risk, managing the risk. It’s been about the difference I started section, this pillar, with: a comparison between the person who swaggers and says, “Oh yeah, I bought this stock and it went sky high.” and the man or woman who says, “I was in this investment and the thing tanked, and this is how I minimized my losses.”
You can appreciate that success is not about getting lucky. It’s about minimizing losses and controlling risk.
And that brings us to education itself as a means to control risk. For students like you and me, education is the most important investment we can make.
Education
One of my pet peeves with the investment industry is that too often they remove the investor from the investing equation. This reminds me of an experience I had growing up when I was cut from the high school basketball team the very first year I tried out. I was tall, but I was also pretty skinny and less coordinated than other players. I had a goal to play in college. But most people suggested that I find a different goal because less than 1 percent of athletes play sports at the college level. By suggesting my odds were less that 1 in 100, they removed me from the equation. They didn’t think of asking me if I was willing to out-work or out-practice 100 people. It was as if they assumed that I could have no impact—no control—on whether or not I accomplished the goal. Chance becomes less of a factor when hard work and training are placed into the equation.
This odds-maker approach is similar to the traditional view of risk and reward. People start at the bottom with the things they feel are ‘safe,’ cash, treasuries—low risk, low reward investments. Stocks…“Oh, but stocks can be risky.” Options, “No, I don’t go for big rewards, it’s too risky.” People think anyone trading the FOREX Market is nuts. The investment industry has dismissed the fact that investors can have an impact on their success…simply by educating themselves.
The traditional view is that to get the big leveraged rewards at the top, you have to push way up on the risk scale.
Ask yourself: Is a BMW a safe car? What if the driver is intoxicated?
Like I’ve said, it’s not the vehicle alone that determines the risk. It’s who the driver is. Certainly, trading the FOREX has significant risk. But how many good people are buying mutual funds and don’t even know what systemic risk is? In my view, the people who understand all the risk in FOREX and are educated in how to manage it have a far greater chance of prosperity in their lives than the uneducated masses riding the mutual-fund roller coaster. Many of the option traders are getting more reward but they’ve also reduced risk because they kn
ow how to hedge it. They know how to do it. They’re educated in managing risk.
Ignorance plays a big part in risk. With education you can manage the high-reward vehicles because you can also manage and control the risk. Once you have mastered a basic risk management toolbox, you will be ready to learn even more sophisticated risk management techniques such as delta hedging and more. The more tools you have, the more strategies you can implement, and the more opportunities you will have.
Chapter Summary
Let’s review some of the important points of Chapter Seven:
1.There are three approaches to dealing with risk.
a.Investors might try to avoid risk. The reality is that there is no place to put one’s wealth where it is not exposed to some type of risk. Money placed in individual stocks faces non-systemic risk. Even wealth placed in diversified portfolios is often subject to systemic risk. There’s risk in buying a home, but if you don’t you may have no place to live.
b.Investors might just take risk. Risk takers can also be gamblers. These investors might buy a home but fail to buy fire insurance.
c.Experienced investors manage risk. If you buy a home you also want to buy fire insurance. Managing risk is the best approach.
2.Sovereign debt crises increase systemic risk.
If the sovereign debt crisis in Europe and also the fiscal and monetary crisis in the United States continue it is likely that the fallout from these problems will affect more than just one or two individual companies but rather the entire market and the entire economy of the world.
3.The use of the word “hope” connotes a situation beyond our control.