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The Totally Hedged Market/Capital Neutral Strategy

Tickers in this article: QQQ SPY


When I first began as a floor trader my capital account was quite small relative to private trading firms, and especially the well-known brokerage firms who traded their firms' capital rather aggressively by my standards of risk. Being a market maker I either had to trade against and/or facilitate their trades should they place an options market order with any of the five primary stocks traded in my pit. Market makers must do just that, i.e., make markets for their own risk/reward.

This market making process took about a N.Y. minute for me to realize that if I was going to succeed in the pit I had better be able to manage my capital, if for no other reason than to do my job of facilitating my options bids and offers. Doing so in a profitable manner quickly advanced in my mind as being my top priority. However, just above that priority of my critical path to market maker survival was that I had to be adept and profitable enough to maneuver my limited capital. Thus, I had to stay within the discipline and strategic plan of attack that I had so carefully designed prior to taking this rather huge life-changing move from being a cushy-chaired investment advisor to a registered options market maker. The plan was built on the following list of personal rules, listed by most important at the top of this list:

1) Keep risk 100% controlled. All positions were to be completely hedged at all times. Thus only positive gamma for each position was the rule. This rule applied to each position, and thus was not to be considered as a portfolio rule. Positions were not to be considered as commingled as per the total gamma of all positions. In other words, one stock or option position with negative gamma which went the wrong way in price (opposite of that negative gamma) was not going to be allowed to seriously blow up my capital.

2) Capital was to be divided into two equal parts, half being dedicated to long stock positions and half being dedicated to short stock positions. Thus, the capital generated by the short sales would be used to literally capitalize the purchase of the long stock side of the balanced portfolio. Years later I would hear or read of various types of funds that would embrace this strategy. For me, that was a quiet compliment.

3) Total positions were to be right, four from the long side and four from the short side. Thus not only was my strategic plan going to be capital neutral, it was also going to be market neutral. Years later I would also hear or read of various types of funds who embraced this strategy. Once again, that was a quiet compliment.

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