This important topic we cover in our book Splitting Pennies is possibly THE MOST importact topic in teaching personal finance, and probably the most misleading concept peddled by Wall St.
Let's face it - Wall St. has a reason to mislead investors, especially retail investors - because they're on the other side of the trade! That's right. When you lose - they win. And due to hedging, they can't actually lose.
The secret world of hedging - Wall St. doesn't want you to know about because like the insurance industry, it allows investors to protect themselves. "Options" are thought of as "Risky" which is a highly potent meme that is reinforced by the regulators:
THE RISK OF LOSS IN TRADING COMMODITY INTERESTS CAN BE SUBSTANTIAL. YOU SHOULD
THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF
YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE
SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD BE AWARE OF THE FOLLOWING:
IF YOU PURCHASE A COMMODITY OPTION YOU MAY SUSTAIN A TOTAL LOSS OF THE PREMIUM
AND OF ALL TRANSACTION COSTS.
IF YOU PURCHASE OR SELL A COMMODITY FUTURES CONTRACT OR SELL A COMMODITY OPTION
OR ENGAGE IN OFF-EXCHANGE FOREIGN CURRENCY TRADING YOU MAY SUSTAIN A TOTAL LOSS
OF THE INITIAL MARGIN FUNDS OR SECURITY DEPOSIT AND ANY ADDITIONAL FUNDS THAT
YOU DEPOSIT WITH YOUR BROKER TO ESTABLISH OR MAINTAIN YOUR POSITION. IF THE
MARKET MOVES AGAINST YOUR POSITION, YOU MAY BE CALLED UPON BY YOUR BROKER TO
DEPOSIT A SUBSTANTIAL AMOUNT OF ADDITIONAL MARGIN FUNDS, ON SHORT NOTICE, IN
ORDER TO MAINTAIN YOUR POSITION. IF YOU DO NOT PROVIDE THE REQUESTED FUNDS
WITHIN THE PRESCRIBED TIME, YOUR POSITION MAY BE LIQUIDATED AT A LOSS, AND YOU WILL
BE LIABLE FOR ANY RESULTING DEFICIT IN YOUR ACCOUNT.
UNDER CERTAIN MARKET CONDITIONS, YOU MAY FIND IT DIFFICULT OR IMPOSSIBLE TO
LIQUIDATE A POSITION. THIS CAN OCCUR, FOR EXAMPLE, WHEN THE MARKET MAKES A “LIMIT
THE PLACEMENT OF CONTINGENT ORDERS BY YOU OR YOUR TRADING ADVISOR, SUCH AS A
“STOP-LOSS” OR “STOP-LIMIT” ORDER, WILL NOT NECESSARILY LIMIT YOUR LOSSES TO THE
INTENDED AMOUNTS, SINCE MARKET CONDITIONS MAY MAKE IT IMPOSSIBLE TO EXECUTE
A “SPREAD” POSITION MAY NOT BE LESS RISKY THAN A SIMPLE “LONG” OR “SHORT” POSITION.
THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN COMMODITY INTEREST
TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO
LARGE LOSSES AS WELL AS GAINS.
IN SOME CASES, MANAGED COMMODITY ACCOUNTS ARE SUBJECT TO SUBSTANTIAL CHARGES
FOR MANAGEMENT AND ADVISORY FEES. IT MAY BE NECESSARY FOR THOSE ACCOUNTS THAT
ARE SUBJECT TO THESE CHARGES TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID
DEPLETION OR EXHAUSTION OF THEIR ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A
COMPLETE DESCRIPTION OF EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE
COMMODITY TRADING ADVISOR.
THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ASPECTS
OF THE COMMODITY INTEREST MARKETS. YOU SHOULD THEREFORE CAREFULLY STUDY THIS
DISCLOSURE DOCUMENT AND COMMODITY INTEREST TRADING BEFORE YOU TRADE,
INCLUDING THE DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT.
THIS COMMODITY TRADING ADVISOR IS PROHIBITED BY LAW FROM ACCEPTING FUNDS IN THE
TRADING ADVISOR’S NAME FROM A CLIENT FOR TRADING COMMODITY INTERESTS. YOU MUST
PLACE ALL FUNDS FOR TRADING IN THIS TRADING PROGRAM DIRECTLY WITH A FUTURES
COMMISSION MERCHANT OR RETAIL FOREIGN EXCHANGE DEALER, AS APPLICABLE.
Whoa- where do I sign? This is an example of how regulators manipulate the presentation of options in order to mislead investors away from something which can protect them from disaster.
Financial tools like options are like any tools, they can be used like insurance, or they can be used as weapons. Take simple construction tools. A hammer can be used to build furniture, or destroy furniture. A hammer can break a window, kill someone - but also it can be used for decades to build fine woodwork (if you are a craftsman).
Building a financial defense line
This is the personal finance equivalent of hedging. Hedging with options for example - should be used like an insurance policy. It's better to have it and not need it than need it and not have it.
Your financial defense line can be a property that's paid for cash that you can live on for the rest of your life, it could be if you are in the car business an inventory of valuable used cars, it could be a pile of gold bars. Preppers are one group that understands this concept well - it's the underlying ethos of prepping.
But the majority of Americans are one paycheck away from disaster. They 'spend money on things they don't need, with money they don't have - to impress people they don't know'
And of course, the problem with writing such an article is the paradox of education. Those who understand this concept, are already doing it, and those who don't understand - they don't believe that they need to know it - they have another opinion! Such thinking is never without punishment in the markets.
Hedging is all about paying for something you do not need, but may need one day, should an unexpected event happen. It's a form of insurance.
There's one kind of insurance that takes this concept too far - life insurance. But that's a topic for another article. Common insurance like homeowners insurance, professional insurances like directors' liability insurance, and others; are a type of financial defense line. For example, did you know in large class action cases where big corporations are involved in fraud - shareholders are settled financially primarily through insurance claims made by plaintiffs attorneys? Commonly it's thought that companies pay out these big settlements but actually, it's mostly insurance companies. Wall St. is a huge user of insurance, and hedging - which is why at companies like AIG, the lines between derivatives trading, opaque contracts, and insurance - was widely blurred.
But you don't need a Wall St. bank in order to create a financial defense line, it can be as simple as investing in something for cash that you may need one day 'just in case' but don't need right now, like a property, a container full of canned food - whatever it is to you.
When you HAVE the financial defense line IN PLACE - THEN and ONLY THEN can you go out into the risky market and take risks. There's a phenomenon that's difficult to quantify, but the fact that you have the defense line, it seems that those investors usually don't lose on the risks they take in the market. The only analogy that can explain this is a Sierra Club study about bears and men carrying guns; it seems that men who hike in the mountains who carry loaded guns are almost never attacked by bears - but also they never shot any bears, which means the men must emit a pheromone that the bears can sniff.
Practically, it's better not to enter the market and take risks if you don't have a defense line. Another example is 'investing money you can afford to lose' - many advisors recommend investing only a percentage of a portfolio (like 5% or 10%) that if the investment is wiped out, the portfolio will remain intact. There's a few demographics that understand this other than preppers - Texas Oil Investors and Silicon Valley VCs.
In Oil Investing, 9 out of 10 wells may be dry, or just barely break even. But 1 out of 10 can be a gusher - 1,000% returns, which make up for the dry and average wells.
Average investors, even if you don't have any retirement or pension, can build a financial defense line - it can mean getting an extra job, doing something for extra income (like selling stuff online) or applying for a research grant you always dreamt of. It's a myth that you need money to invest. In fact, most startups are started with 99% persperation and 1% inspiration. Without money though, you'll have to put MAJOR WORK into your project to really build equity. In a simple example of a housing project, that means doing the labor yourself which can be 60% - 70% of the costs. In a business, it means you'll have to do 10 jobs, instead of hiring an accountant, a webmaster, and other things.
Hey - it's better than sticking a crayon up your nose. Extended warranty? How can I lose?