February 18, 2011
How to Outsmart Goldman Sachs
Chris McKhann
Many companies tie their executive compensation to their stock price, which theoretically aligns the goals of the employees and management. But would hedging those shares with options--removing downside risk as well as upside gains--change that motivation?
Apparently such hedging is quite common at Goldman Sachs. Last weekend the New York Times ran aninteresting piece on partners' use of options for hedging equity exposure at the firm.
Most of us probably aren't worried about how much Goldman executives are making or losing on their stock holdings. But if you own the stock yourself, you might be interested in the hedging techniques of those who have lots to lose.
Some question whether these executives should be able to hedge in terms of aligning compensation with incentives, essentially doing an end-run around changes in pay practices. Others argue that hedging is a wise alternative to diversification. But more interesting to us is what the "smart guys" at Goldman are doing in terms of hedging and what we can do about it.
According to the Times article, "For Goldman partners, the most popular hedging strategy was covered calls." There's just one problem: Covered calls do not involve much hedging at all.
Covered calls take in income but limit the upside while giving a small downside cushion, but they are essentially a bullish strategy that doesn't provide any real protection. (The partners apparently do usecollars, which match covered calls with protective puts to limit both the upside and the downside.)
But what is really interesting is that there is that there is likely some sizable trading going on here. The story says that one executive made $675,000 on 11 covered-call transactions--and retail option traders may be able to take advantage of that.
Here's why: Covered-call selling drives down call prices, and put buying inflates those prices. So savvy option traders may have an opportunity to take advantage of the market forces that these execs are creating to protect their long positions.
Apparently such hedging is quite common at Goldman Sachs. Last weekend the New York Times ran aninteresting piece on partners' use of options for hedging equity exposure at the firm.
Most of us probably aren't worried about how much Goldman executives are making or losing on their stock holdings. But if you own the stock yourself, you might be interested in the hedging techniques of those who have lots to lose.
Some question whether these executives should be able to hedge in terms of aligning compensation with incentives, essentially doing an end-run around changes in pay practices. Others argue that hedging is a wise alternative to diversification. But more interesting to us is what the "smart guys" at Goldman are doing in terms of hedging and what we can do about it.
According to the Times article, "For Goldman partners, the most popular hedging strategy was covered calls." There's just one problem: Covered calls do not involve much hedging at all.
Covered calls take in income but limit the upside while giving a small downside cushion, but they are essentially a bullish strategy that doesn't provide any real protection. (The partners apparently do usecollars, which match covered calls with protective puts to limit both the upside and the downside.)
But what is really interesting is that there is that there is likely some sizable trading going on here. The story says that one executive made $675,000 on 11 covered-call transactions--and retail option traders may be able to take advantage of that.
Here's why: Covered-call selling drives down call prices, and put buying inflates those prices. So savvy option traders may have an opportunity to take advantage of the market forces that these execs are creating to protect their long positions.
Selling slightly out-of-the money puts that are overpriced and buying calls that have lower volatility gives you a long position with potentially less risk than just buying the stock outright. (See our Educationsection)
This is not advocating that you run out and buy GS, but if you are going to anyway, you might consider using the options in this way to increase your odds.
The volatility chart above shows that GS options are usually overpriced, at least in terms of the implied volatility being higher than the historical volatility. Creating longs by being on the other side of those "smart guys" may just make you the smartest guy (or gal) in the room.
The volatility chart above shows that GS options are usually overpriced, at least in terms of the implied volatility being higher than the historical volatility. Creating longs by being on the other side of those "smart guys" may just make you the smartest guy (or gal) in the room.
(Chart courtesy of iVolatility.com)
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