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A Missed Opportunity

May 19, 2011 | About:
In a post last week (Revisiting a Losing Market-Neutral Trade), I mentioned a market neutral trade where I got stopped out of the short side for a loss. I got stopped out of the short side of a more recent market neutral trade Toreador Resources Corp. (Short TRGL, Long IMO) for a gain, but I missed an opportunity in not buying puts on Toreador after getting stopped out.

Toreador Resources Corp. (TRGL) versus Imperial Oil Ltd. (IMO)

The chart below shows the performance of Toreador and Imperial Oil Ltd. (IMO) from when I entered the trade on 3/31/2011 until when I exited on 4/21/2011. I started out with 24% trailing stops on both sides of this trade, but as I noted on Short Screen at the time, I tightened those trailing stops on both sides (to 8%) on 4/19. So I got stopped out of Toreador early on 4/21 -- at $7.58, instead of $8.85, which is where it closed that day. Once I got stopped out of Toreador, I sold my long position in Imperial Oil. Overall, it wasn't a bad trade: I made 3% on the long side and 30% on the short side, for a combined return of 16.5% on the combined trade.

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Why Toreador popped on April 21

The company, an oil & gas E&P with its operations in the Paris Basin, had been under a cloud as the French government considered banning shale exploration for environmental reasons. On April 21, the company commented on an interim report about shale exploration by a French government agency, but there was nothing conclusive about that report; the pop on 4/21 looks like it was a simply a short squeeze.

Performance of Toreador from 4/21 until this week

The chart below shows how Toreador shares have done since I got stopped out on April 21.

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Why this was a missed opportunity

Because the bearish case against Toreador hadn't materially changed on April 21, so I should have taken advantage of the bounce and bought in-the-money puts on it then. I didn't think of that at the time.

Buying puts on a stock after getting stopped out of a short position

The odd thing is that I did do that when I got stopped out of the short side of another market neutral trade (Short JOE, Long GTY) for a loss earlier this year. Since I thought the bearish case against St. Joe (JOE) remained intact, I bought long-dated, in-the-money puts on it (which I'm still holding). It's something I'll consider going forward when I get stopped out for gains as well.

A reminder about hedging versus betting

Those puts on St. Joe were a speculative bet against the stock; because of that, I bought in the money puts on it, consistent with Tim's guidelines about buying options in Chart Your Way to Profits. That makes sense for directional bets (when you are willing to pay more to reduce the odds against your bet) but would be sub-optimal in most cases for hedging (when you want to get a certain level of protection at the lowest possible cost).

If I were hedging, I would enter the symbol of the stock or ETF I was looking to hedge in the “symbol” field of Portfolio Armor (available as a web app and as an Apple iOS app), enter the number of shares in the “shares owned” field, and then enter the maximum decline I was willing to risk in the “threshold” field. Then Portfolio Armor would use its algorithm to scan for the optimal puts to give me that level of protection at the lowest cost.

On rare occasions (I’ve seen it happen once, so far) the optimal puts Portfolio Armor presents might be in-the-money; in most cases however they will be out-of-the-money.

My most recent market neutral trade

I entered another market neutral trade last Friday, long ALB, short ADES. More details on that at the link.

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