I’ve mentioned in the past that I’ve somewhat hedged my brokerage portfolio by buying puts on the NASDAQ 100 (QQQQ). These hedges have performed as hedges would be expected to perform. They’ve sheltered my portfolio from the some of the volatility that has been rampant in the market. Below are a couple charts comparing the performance of my portfolio with the NASDAQ Composite, S&P 500, and the NASDAQ 100. The NASDAQ kicked my ass in 2007. At least I outperformed the S&P 500, though barely. The Nasdaq 100 which I brought put options on really kicked my ass.

Green Line = My Brokerage Account, Blue Line = NASDAQ Composite

Green Line = My Brokerage Account, Blue Line = NASDAQ S&P 500

Green Line = My Brokerage Account, Blue Line = NASDAQ 100

The meaning of hedge has become quite muddled as “Hedge” Funds run rampant in the financial world. Inigo Montoya would likely question many a hedge fund manager on the use of the word hedge - “You keep using that word. I do not think it means what you think it means.” The managers at the Bear Stearns funds who lost billions on subprime clearly did not have offsetting positions.

Hedging as it’s properly defined means to minimize or protect against a loss. Hedge Funds despite their name do not by rule have to do this and they don’t, though the name has stuck. Personally, I’ve purchased put options for this purpose, to hedge my portfolio against a market downturn that I feel is likely. The problem of course is that like many people I’m probably too greedy for my own good.

The options that I have purchased have expiration dates of at least a year out. They are currently “in the money” meaning that the price at which I have the option to sell is higher than the current trading price. For example I own an option to sell the QQQs on January 16th, 2010 for $55. Right now the QQQ trades at $50.50, a price lower than what I have the option to sell it for. However once January 16th, 2010 has passed those options will be by definition worthless. I have to sell or exercise on or before that date. As a result, those hedges only give me protection until January 2010.

The result of all this is that I want to make extra money on my hedges and make money on my underlying investments. If I really felt like the puts were true hedges then I wouldn’t have thoughts about trying to make money off of them, but I do. The key to maximizing profits in all of this is timing. For example let’s say I brought shares of the NASDAQ 100 for $45 sometime in the past and then brought puts to sell them at $60 when the QQQs were trading near $60. Because the QQQs are now trading near $50, I would be able to sell my puts and make a quick profit on the options, and enjoy the full benefits of a rising market on my shares of the QQQs. However, I would then be without protection if the NASDAQ were to fall even further. The problem with trying to time the market is that usually it’s not enough to be right once - you really need to be right at least twice. Someone who’s truly hedging should always hold onto the hedge and the underlying investment being hedged. As much as I like to believe I’m such a disciplined investor, I’m remain unconvinced that I actually am.