Benjamin Graham On The Art Of Hedging

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Every so often the internet throws up an undiscovered gem from the world of value investing. The latest offering is a selection of articles written by Benjamin Graham in 1920 for the Magazine of Wall Street.

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These articles cover several topics including analysis by Benjamin Graham on several securities, giving us a fascinating insight into the way the Godfather of value investing analyzed securities and how he looked for value.

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The article I'm looking at today is titled "The Art of Hedging." It is a lengthy description of hedging and the strategies the average investor can use to hedge their positions profitably. Throughout the article, Graham not only provides an in-depth look at the different strategies, he also gives different examples of how each one can be employed to generate the most profit.

The Art of Hedging

Benjamin Graham starts the article with a broad description of hedging activity and a simple strategy investors can use to protect against losses:

"In the securities market a form of hedging very common on foreign Stock Exchanges is the use of puts or calls against long or short stock respectively. If a man purchases one hundred shares of U. S. Steel at 106, for instance, he might limit his possible loss by buying also a put good for thirty days at 102. This means that however low the stock may break, he has the right to sell it at any time within the next month at 102, so that his maximum loss under the worst possible conditions would be $400 plus the cost of the put (and commissions). This arrangement is often preferable to a stop loss order, because it guards against loss through a temporary Auction. Should Steel drop to 101 ½ and then rally to 115 during the month, the man with a stop loss order at 102 would have been forced out at his limit, while a put would have carried him safely through to a large ultimate profit."

The article then moves on to focus on the strategy of using bonds to hedge stock positions and vice versa. Graham discusses using short positions to hedge long bond positions such as purchasing $10,000 of Lackawanna Steel convertible 5% bonds, due 1950, and at the same time selling short the stock at 100. In this scenario, if the stock continues to head higher, traders will be forced to convert the bonds to "make delivery of the shares we sold." In this scenario Graham notes, the downside is limited to $25 excluding commissions. In practice, the stock declined to $83 while the bonds traded at $94. Selling at this level Graham writes, "would show a net credit of $1,100."

After several more examples, he goes to discuss the advantages of acting on situations when they present themselves, rather than waiting for the perfect opportunity:

"Even experienced "hedge artists” often forego the chance of excellent profits because they wait in vain for the possibility of loss to be reduced to too small a figure. For example, in the ill-fated boom of Allied Packers stock last October, it sold at 66, while the convertible 6% bonds were quoted at 91. Each $1,000 bond was convertible at any time for thirteen shares of stock, so if bought at 91 they constituted a call on the stock at $70 per share. The purchase of eight bonds at that time, together with the sale of 100 shares of stock at 66, would have subsequently shown no less than $3,200 profit, for the stock sold down to 26 with the bonds at 82. On the other hand, no matter how much higher the stock might have gone, the loss on this deal was absolutely limited to $400—the difference between 66 and 70. In this case, however, the temptation was to buy the bonds, and to wait for the stock to go a little higher before selling. Alas! the wait would have been in vain."

The next strategy Benjamin Graham covers is using convertible preferred stocks.

"Convertible preferred stocks present the same opportunities for hedging operations as do the bonds. A current example is Gilliland Oil preferred, which is exchangeable at any time for twice as many shares of common. On January 15, the preferred could have been bought at 100 and the common sold at 49. The maximum loss, in case of a great advance of the common, would have been two points per share of preferred, which in fact would have been made up by the $2 dividend coming off the latter on February 2. As it happened, two days later the common was down to 43, while the preferred was actually higher at 101. Thus on a hundred shares of preferred and two hundred common, there was a chance for $1,300 gross profit in two days, with negligible risk."

And then we have the "Straddle," a method of hedging that involves buying and selling the rights to subscribe to new stock. Graham writes that this method is perhaps the best way to trade rights, although it is very "important here that the price of the rights be very low, and they still have a substantial period to run." Trading rights has many similarities to using options. However, Graham seems to prefer this method because rights "carry a more attractive option in proportion to their cost" than the usual "30-day privilege" attached to options.

Here's an example of rights trading given in the article:

"On December 29 last, B. R. T. certificates of deposit sold at 5, while the undeposited stock was quoted above 10. It was true that the deposit agreement made withdrawal unusually difficult, but this was an entirely inadequate reason for the free stock selling at twice the price of the certificates. The two represented exactly the same property rights, and further there was enough stock in the control of the committee to enable it most probably to force the undeposited shares to accept their reorganization plan, when finally adopted. Hence the investor was running very little risk in buying 200 B. R. T. certificates at 5 and selling 100 shares of free stock against them at 10 ¼ . Temporarily the spread might have widened perhaps, but ultimately the two prices were bound to approach each other. The latter happened very quickly in effect, as a few days later the certificates had advanced to 7 while the stock remained at 10 ¼. Today the trader could sell his certificates at 10 with a gain of $1,000, and cover his stock at 13 ¼ -a loss of only $300—showing an excellent net profit on a very modest commitment."

These methods of hedging all have their benefits and can be used to arbitrage as well. Graham concludes in his article that these methods are attractive strategies for traders because they are all "based on exact information and analysis, and their success is usually entirely independent of market movements." He goes on to conclude: "at the present time, when the outlook is so clouded with uncertainty, the trader may well turn his attention for a while to the unspectacular, but safely profitable, business of hedging."

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