When Hedging Turns into Compounded Loss

Whenever you start talking about “second derivatives” to explain market action, you know there’s likely a problem.

And the recent sharp market volatility does have something to do with second derivatives – in this case, something known as “gamma hedging.” It’s practiced by arrogant traders with a masochistic streak, who don’t want low volatility to short-circuit their option trades. Remember, option premiums are inversely related to market volatility. Thus, it might seem smart to short volatility – meaning the Vix – to protect an option position.

It’s a great strategy until it stops working. That’s when the hedge turns into a compounded loss.

The last time we saw this brand of stupidity was during the October 1987 crash. Everyone wanted portfolio insurance, which they thought they could get by selling futures to protect long positions. The trouble was that when the market started to really fall, and everyone started doing the same thing, the futures started running the market. The result: a vicious circle that almost destroyed Wall Street.

In 2008 the problem wasn’t primarily quant-related trading, though it certainly didn’t help. Rather, it was quant-related packaging. Traders convinced themselves that by mashing together a bunch of inferior products, they ended up with a superior package as a hedge. We know how well that worked out.

My guess, or maybe hope, is that this time around the gamma hedging wasn’t itself a game changer but that it exacerbated a downturn that was caused by a change in market leadership.

Typically a change in leadership leads increased volatility and often a correction. My stock indicators, while they have improved to neutral (and, yes, I certainly wish I had stayed with my short position a couple of days longer), still are not signaling the end of the correction or what might better be called a transition to commodity leadership. Our commodity- and gold-related indicators are stronger than our stock indicators but still not begging to added to a Pot 1 trade, which is reserved for clear buys in ETFs.

So I am going to hedge (I hope more sensibly than the traders did). Right now we have a long position, Pretium Resources (NYSE: PVG), that in my view has dramatically overreacted to a run of the mill disappointment. I believe the stock is worth many time its current price. You may have to endure a little more pain, but it should be worth it.

I also have recommended an Argentinian online travel service, Despegar.com (NYSE: DESP), a leading player in online travel bookings and related services in Latin America. The connection with market action and the indicators is the strength in commodities, since many critical commodities like lithium, copper, and silver are produced in Latin America. This zero-debt, positive-free-cash-flow company should be able to dramatically ramp up its operations. The stock price will benefit as the company becomes better known. Note that this trade is in Pot 3, our least aggressive Pot.

Stock Talk

Stanley

Stanley

I haven’t seen any trades from you recently, I am not sure if there has been any.
Stan

Jim Pearce

Jim Pearce

Brian Mccollom

Brian Mccollom

What are the indicators doing? There are no trades, no communication. Getting very disappointed with this service.

Scott Chan

Scott Chan

Dear Brian,

Aggressive Trader merged with Systematic Wealth and then Real World Investing. This morning there was an option trade for Real World.

You should have received that alert and you should have access to Real World Investing. If you do not, please let me know or call 800-832-2330 and speak with a customer service rep.

Scott Chan

Scott Chan

Dear Brian,

To follow up on my reply, I checked with customer service. They confirmed they are already sending you alerts for Real World.

But again, if you haven’t gotten these alerts, let me know.

In any case, nothing new will be posted on this Aggressive Trader website. New indicator trades will come from Real World Investing.

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