Special Situation Investing

Tuesday, February 20, 2007

Goldman Sachs (GS) - Portfolio Insurance Puts

I can't help feeling increasingly nervous as the major indexes continue their ascent. While we are certainly not seeing the degree of optimism in the 99/00 bubble it does seem that the markets are warming up to the idea of prosperity. I however, have my doubts. Now I don't want to be one of those fire and brimstone perma-bulls who is constantly predicting the end. However, I feel there is a realistic and poorly discounted chance that the economy will hit a snag or worse.

It could be housing, consumer debt, depreciation of the dollar, or some unforseen series of events. I really just don't know. However, I am not willing to continue to hold the overwhelming bulk of my net worth long in equities.

As such, I have decided to purchase some puts to offset the risk. I don't normally condone hedging as I feel it generally just diminishes results. However, the risk premium on certain companies is sufficiently low that it seems like a good bet. Today, for instance, I bought $180 Jan/08 puts on Goldman Sachs (GS) for $5.50 an option. For those new to options, what this means is that for $5.50 a share I have the right to sell GS for $180 up until the third friday of January 2008. Of course, this only makes sense if GS dips below $180 over the next year, otherwise the position is a complete loss.

Let me give you an example. If the stock price were to descend to say $150, well you could buy the shares for $150 and sell them for $180, providing a $30 spread. Given that you bought the options for $5.50 and generated $30 from the trade, this scenario would provide a 445% profit. It is more complicted than this as the options are worth more than the spread based on the amount of time remaining before expiration. Also, you don't actually need to do the buying and selling of the shares, you can just sell the options and let someone else worry about it.

Back to Goldman. If you don't know, Goldman Sachs is probably the preeminent investment bank of the world. As the number of IPO's and leveraged buy outs have surged, GS has benefitted. They also operate significant internal trading operations which have generated substantial profits lately. Over the last few years I have watched their stock price explode from the $80-90 range in 2004 to over $220 at the time I sit writing this.

Now I am not saying that GS is not a good company. I actually think it is an excellent firm with a strong reputation and I would never short the stock. However, it is highly leveraged to the success and failure of the stock market. Should things turn south, Goldman will feel the pain and in amounts proportionately higher than the rest of the market. There is also, always the small chance of failure of some magnitude by it's investment division even in an up market. Look at the demise of Amaranth for example. I have heard many good things about GS's investments, how they always seem one step ahead of the market and the massive amounts of profit they generate. I am skeptical. People make mistakes, computer models have flaws and limitations, six-sigma events DO happen in the market.

I should mention that the options I have purchased represent a VERY small proportion of my portfolio. Roughly 0.5% of my net stock holdings. So I can afford to take a complete loss on the thing and it would just be a marginal tick off my gains for the year. However, in a nasty market, one where the stock market gets hit 20-30% I can envision turning a profit of 5-15x my investment, thereby buffering my other losses.


  • I agree with you however I see problems with GS. Prime trading,SANYY,collusion Thain-Nyse,trading in cmmodities they are not holy than thou

    By Anonymous Anonymous, at 6:19 AM  

  • I like your thinking process, the Jan08 put is well worth it. I share similar sentiments with you in terms of the current market, and its potential impact to GS. Well written!

    Siyu LI

    By Blogger Siyu LI, at 1:06 PM  

  • Insurance rate is a factor used to determine the amount, called the premium, to be charged for a certain amount of insurance coverage. Risk management, the practice of appraising and controlling risk, has evolved as a discrete field of study and practice.

    By Blogger king, at 9:53 PM  

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