Hedging Macro Trend Risk

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Hey fellow Slopers,

My largest long position is an Australia-based nano cap I've mentioned in the comments on occasion, Alloy Steel International (Pink Sheets: AYSI). AYSI uses a high tech, proprietary process to manufacture protective wear plates for mining equipment. Essentially, the company is a picks & shovels play on the mining industry (particularly iron ore and coal mining). As such, it has the potential to benefit from the macro trend of Chinese demand for those commodities.

As is typical of nano caps, there are no options traded on AYSI, so it's impossible to use options to hedge against AYSI's idiosyncratic, or stock-specific risk — some of which it has exhibited over the last week, as the stock dropped 25% after reporting a sequential drop in earnings in its fiscal Q1, following its release of record Q4 and annual numbers in February:

The way I try to manage AYSI's idiosyncratic risk is by keeping my cost basis low (e.g., by buying more when the stock tanked to the low .40s last year, and not buying more when it spiked to $1.89 earlier this year, after releasing its 2010 numbers). How to hedge against its macro trend risk though, i.e., a big dropoff in Chinese commodity demand?

One way is to look for an optionable stock that's exposed to the same macro trend risk. BHP Billiton (NYSE: BHP ) fits that bill here (and is also a good fit for another reason: it's one of AYSI's largest customers). If you've got a position in AYSI, you could look at an equivalent dollar amount position in BHP and consider buying optimal puts on it as a hedge against macro trend risk. Using Portfolio Armor (available as a web app and as an Apple iOS app), you could simply enter "BHP" in the symbol field, your dollar-equivalent number of shares in the "shares owned" field, and the maximum decline you're willing to risk in the "threshold" field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost. What number should you use as a maximum decline threshold though? 

In previous posts on hedging, I mentioned that I often use a 20% decline threshold when hedging (i.e., I hedge against a greater-than-20% loss), and that I got that idea from a comment fund manager John Hussman made in a market commentary in October 2008:

An intolerable loss, in my view, is one that requires a heroic recovery simply to break even… a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).

I wouldn't use a 20% threshold in this case though. If there's a big dropoff in Chinese demand for iron ore, I'd expect a much bigger decline in BHP's share price. How much of a decline? Take a look at the 5 year chart of BHP below. 

The lows of late '08 could be attributed to the general end-of-the-world atmosphere post-Lehman, so I'd start with BHP's share price in Q1 '09. By the end of Q1 '09, some of the immediate panic of the global financial crisis had lifted, but there were still fears about a dropoff in Chinese commodity demand. At its lows in Q1 09, BHP was trading at about 10x its trailing earnings. Currently, it's trading at about 16.5x its trailing earnings (of $6.13). So if BHP's valuation dropped to 10x its trailing earnings today, the stock would be trading at $61.30, about a 40% drop from BHP's closing price Wednesday of $101.16. So I'd use 40% as my threshold if I were looking for optimal puts on BHP as a hedge against the macro trend risk of a dropoff in Chinese iron ore and coal demand.

Checking Portfolio Armor now, the cost of hedging against a >40% drop in BHP over the next seven months, using the optimal puts for that, is 0.86% of your position value. I may pick up a few of those optimal puts this week, while the VIX continues to hover near its two-year lows.