My last posting was about a "loss" that was pending in our fund from a significant drop in price from ERF. A couple of readers asked why we are not in depression or panic mode due to the size of the pending loss. The reason is simple hedge fund traders learn to accept losses from time to time. We try to keep these losses to a minimum, but sooner or later they happen. Most times the losses for our fund will be several thousand dollars, such as $2k or $3k. Hedge fund trading many times is nothing more than run and gun offense with only prior thought given to how to play defense. Defense is played with selection of securities we trade, after that we trade with an eye towards how fast one can turn over the trades and how much premium you get from each trade.
ERF offered significant premium month to month and we weighted that premium income versus the risk involved in the trade. That risk is mitigated by extensive research to keep us from being exposed to fundamental risk we do not know. We knew the risk in ERF so we accept the loss with the understanding it could happen. We are also sitting on a medium size loss in GG right now as well, again we knew the risk involved in GG but decided the premium income outweighed the risk. Point is over the many years we have traded ERF we have made lots of money even with the pending loss. We expect similar results from GG which we only started trading last year.
Run and gun trading means cash flow. Cash flow even when you are deep in the money on the security. Option trades for premium income. If we are sitting on a capital loss in the stock using research and prior experience we make a decision about what price to trade on the option which will bring us the best income with the least loss all the while knowing turnover is more important than the negative capital situation. Once you are assigned out of the stock you reassess the security deciding if the risk is worth taking another option position.
Essentially because the fund is based on a equity margin position even if we make any profit we are making money from nothing but your effort and time because if we did not use the leverage we would still have the equity position. Not using the equity position means that opportunity goes to waste. I know this is deep in the weeds thinking, but many hedge funds operate just in this manner. We have noted that the fund could essentially make 12% almost guaranteed if the fund took less risk with security selection taking option positions on regulated electric utilities and stocks such as Johnson and Johnson where price movement is very low and risk almost non existent. That would be nice but not as much fun as matching wits with those we consider top dogs in this business. Years where performance is above 20% makes for some good vibes. Many of the people you see on CNBC and other financial shows essentially have made all the millions they desire and now are using the capital they have to make the 12% and basically retire. You could not find a federal government bond in their portfolio.
The STI fund uses a moderate risk approach selecting securities where the risk is smaller while adding in some that offer more bang and more risk. We have never had a negative year using this style and can not see any situation where we could ever see a negative cash flow year. Several people who keep up with our model take some of our risk adverse stock selections and make very conservative option trades to make additional cash flow. From time to time they note that they left cash on the table since the call option was taken from them when the stock was several dollars higher than the strike price. That can make one not happy I suppose and at one time it did us. However again turnover and cash flow is king. As I explain to them getting the last few dollars of profit is best left to those willing to take the significant added risk of buying the call or put from you. Let them have it and take the fact that your capital is now freed up for another option position, which will offer additional profit for you.
One last point. Selling an option is playing with the house's money, buying an option is playing with your money, since most options expire worthless in the end. I like using someone else's money to make my money as I noted in a posting back sometime ago on how people get rich using someone else's money.
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