A Hedge is a Hedge Until the Hedges Burn Down

Flash! In the news! Another brain surgeon who likely knows nothing about something or maybe he knows everything about nothing?
Anyway, I just read one of the more asinine things I have read this week.

“If you are looking for a hedged play on Prologis (PLD) the stock seems like it could be a candidate for an October out-of-the-money bull-put credit spread below the $35 dollar range.

Let’s look a little closer to see if this is really a hedge at all.

Buy the October 30 put (so you can put it to someone else at $30) and then sell the $35 put (someone can put it to you at $35).

Someone gets to put it to you at $35 but you get to put it to someone else at $30. Hedged? Sort of. But what is the real risk reward here? I sell the $35 and receive 85 cents. I buy the $30 strike for 50 cents. My net credit is a whooping 35 cents. What is my risk? The difference in strikes minus the credit. $35 - $30 = $5. $5 minus $.35 cents is $4.65. Reward is $.35 and risk is $4.65. As Aladdin would say….I DON”T THINK SO!

I receive $.35 cents for $4.65 worth of risk? Well that sounds tasty. Let’s publish it in a story? Allow me to publish something else. When a company has a minus sign in front of their levered free cash flow, you should run and hide. In fact you should buy the most out of the money puts you can. Because it is not if this common is worth nothing, it is when it is worth nothing. How about that for a wake up call? Dear sir or madam, your hedge should have only been considered a hedge if the risk was LESS than the potential reward.

When the unknown becomes known. This is exactly where we are now. These are the trades that banks took all day long as a part of their “proprietary trading”. And proprietary trading is where 80% of investment bank profits come from now. The house is being turned upside down. The models all worked…until they didn’t. If you want to buy any of these financial stocks, you may want to turn your screen upside down before you do. It’ll make you feel better. You’ll feel like they are going up. They’re not. They are going down. Yes, from here. They are going down more.

Peace.