Kudy Hedge Fund: Behind the Scenes

For the past few weeks, we have done an explainer about each of the funds. You must have been wondering for a long time about what happens in the Kudy Hedge Fund. Why is this fund so volatile? What makes it tick?

Today, we will take you behind the scenes and explain the step by step process of how and why we select a specific trading strategy. We will then structure a trade and follow it for the next two weeks. This will give you an idea of how we make money in the Kudy Hedge Fund. So here we go.

We are interested in structuring a trade around Apple. Apple is a well-loved company and also the most capitalized stock in the world. So what kind of trade can we structure for it?

Step 1: Determine The Direction

Apple has taken a hit over the past few weeks, and it has lost 17% from its highs. Nothing has changed fundamentally about the company, so this pullback must be a normal event. Perhaps the stock is reacting to interest rate changes in the United States, but the company is not likely to be massively affected by the change in rates that its profits would drop by 17%. On the technical side, Apple share price at $199.90 is below its 50-day moving average at $129.35 and quite close to its 200-day moving average of $115.71. Bollinger Bands say something really bad has to happen for the stock to drop below $117 over the next 20 days. This means that there is very strong technical support just below the current pricing of Apple. On the balance, the stock is more likely to go up or trade sideways than drop over the next two weeks.

Step 2: Determine The Strategy

Now we know that Apple is more likely to go up in price or trade sideways than drop in value. In addition, we really want to buy the shares, but we don’t want to go into the market to buy the shares directly because of the possibility of a drop. Lastly, we want to be able to earn income without necessarily buying the shares. This is where we now take a look at the implied volatility of Apple options. The implied volatility is 10% higher now than it was a month ago but very slightly lower than it was a week ago. Option traders believe that Apple price may be reaching a bottom just like we thought in Step 1, which further solidifies our belief. Yes, we know that anything can happen and the bottom might fall off, which means we can’t just go all out and throw caution into the wind.

Putting all these thoughts process together, the strategies we could employ range from a standard credit put spread to a call diagonal or a call calendar or just jump into a naked short call. (Don’t bother too much about technical jargons: we just want to talk you through our thought process. The fun stuff is still ahead.) We have decided to go for a more exotic strategy called iron butterfly because we really want to buy the stock.

Step 3: Structuring The Trade

At the time of structuring the trade, Apple had gone up from a closing price of $119.90 on Friday to over $123.00. Our initial trade structure was a specialized type of in-house trade that we call explosive iron condor. We wanted to sell a short put option at $125 and buy a long put option at $120 and then sell a short call option at $130 and buy a long call option at $135. We decided to settle for this more innocuous iron butterfly. We sold the iron butterfly for a price of $3.26, meaning that the risk is capped at $1.75. We don’t want to go too deep into the mechanics of the trade so we will make it as simple as possible. We sold both call and out options at $125 and then bought a long put option at $120 and bought a long call option at $130.

Here is the summary of the parameters, based on 10 contracts of this strategy:

Credit received: $3,260

Total risk exposure: $5,000

Maximum loss that can happen: $1,740

Margin: $5,000

Cash set aside to purchase the stock if it hits our target: $127,500

It doesn’t matter what happens to the share price, the maximum loss we can get from this strategy is $1,750, even if the stock drops to zero. At some point we will buy the shares, but what is the fun in it if we tell you how that is going to happen? You might also be asking, “Why not just buy the shares right away?”. It will no longer be a hedge fund if we bought the shares right away. We want to make money from this trade regardless of what happens to Apple stock. Even if it drops to zero. And how will that happen? The next two weeks will tell.

Weekend update (27.03.2021)

Apple shares came down again from Monday’s value when we executed the iron butterfly trade. The position of this trade has gone up in value from $3.26 to $3.31. This is a loss of 1.5% for the week as it is a net short trade. We will only make money when the prices of the short positions come down. It may not be so clear cut, but the iron condor is made up of two different strategies — a bull put plus a bear call. The bear call part of the strategy made money but the bull put portion of the strategy, which we intend to purchase the Apple stock lost money. This is a good sign.

You may ask, how can losing money be a good sign? Well, that’s because we don’t really care too much about the direction, and the price range is staying exactly where we want it to be while we allow time to do its work on the option values.

Depending on the price of the stock on Monday, we intend to convert this iron butterfly strategy into a calendarized iron condor. This means that we will take profits from the bear call part of the iron butterfly (remember this part has already made money, only that the bull put lost more money than the bear call made), which we sold at 125 short call and 130 long call, and then roll out into April 9th maturity at 127 or 128 short call and 132 or 133 long call, depending on Apple price.

The reason we are doing this will become clearer if the stock behaves exactly the way we want it to behave over the next two weeks. For now, that’s our in-house secret. We will provide an update after the trade has been executed on Monday.

Update (29.03.2021)

And we have another update today. Apple stock refused to do anything, but as planned, we simply took profit from the bear call part of the iron butterfly. This part was bought to close for $0.98 (remember that this was a net short position). The bull put part of the iron butterfly now trades at $2.97. After netting off all the trades, the entire value of the position is now trading at $1.99. Given that we entered the trade at $3.26, we are now in a net profit of $1.27, or $1,270 (we are holding 10 contracts).

Apple stock has not gone anywhere, but we are already in profits and we are yet to buy the stock. But we are not done; the fun is just starting.

Remember that in the weekend update, we intended to enter a calendarized iron condor, but since the stock has not gone anywhere, we simply rolled out the bear call. We took profit from the Apple 1st of April 125 short call and 130 long call and entered another trade: Apple 9th of April 125 short call and 130 long call. We did a calendarized iron butterfly instead. I don’t want to go too deep into the mathematics, but the entire net position, excluding crystallized profits, is now $3.67. This is a net short position, so as this value drops, we make money.

Remember that right now, we have locked in a profit of $0.98 or $980 from the trade.

This is a complex trade, but to make things really simple, the summary is that at the moment, we have reduced our risk exposure. The maximum loss we could experience from this trade started at $1,740. If we add $3.67 (the current position) to the crystallized profit of $0.98, or total net credit is now $4.65. The implication is that the maximum loss we can experience from this trade is now $5.00 — $4.65 or $0.35 ($350). If the world goes belly up tomorrow and stock prices crash to zero, the maximum loss we can now have has been capped at $350 on a trade for which we have set aside $127,500 to buy the shares.

In a few days, you will understand why we did not walk into the market to buy Apple shares: the market is going to pay us to buy the shares. Stay tuned.

Update (02.04.2021)

We finally bought the shares! We are now proud owners of Apple shares. Part of the bull put strategy was to buy Apple at $125/share. You may be wondering why we would buy the shares at $125 when the market price is currently at $123, and be happy.

A quick explanation:

1. We captured a profit of $980 from closing the initial bear call of the first trade; now put it aside
2. As part of the contract to buy Apple shares at $125, we were paid upfront fees of $1.96 per share in the bull put portion of the original iron butterfly. The contract closed last night, and we received cash of $1,960
3. Total cash receipt from the iron butterfly comes to (1 + 2 above) $2,940
4. We bought 1,000 shares of Apple at $125, which comes to $125,000
5. Now deduct the cash received from $125,000, and our total net purchase amount drops to $122,060
6. At current market price of $123, the market value of our Apple shares is now $123,000, meaning that we are now sitting on a profit of 0.7% off the bat

The question you might have now is whether it was all worth it. Okay, here is a small piece of information I have not added: we are still holding the Apple bear call that we opened on 29th of March. We opened it at $0.70, and it is now worth $0.54, which means we have a small profit of $0.16 or $160, which we have not added. This bear call is expected to mature on April 9th.

While the net profit is just 0.7% in two weeks, this is equivalent to 18.2% annualized return. This falls within our target return of 15% — 30% per annum on the hedge fund. But this thing is not over yet. Remember that when we opened the iron condor, Apple was selling at $123.60. The price has come down to $123.00, and anyone who bought the shares then will be sitting on a loss, but we are sitting on a gain. Our strategy is to make money regardless of the market direction. We don’t buy or short and then hold and pray that the price goes up or down. Whatever the price does, we are good with it.

Hang on till next week.

Update (05.04.2021)

So the entire market went parabolic between last week and today. I will not be surprised if there is a pull back before the end of the week. Apple stock also blew past the $125 mark, and it is currently selling at $125.66 as the time of writing this.

A quick recap: we have 1,000 shares of Apple, which we bought at a net price of $122.06, and we also have a bear call, which we sold at a net price of $0.70.

We just completed an adjustment, selling the Apple $130 long call option at $0.12. We lost $0.09 on this option, and this loss will be added to the cost basis of our shares. Based on this adjustment, we now have Apple shares, purchased at $122.15, and a short $125 call on Apple, which we sold at $0.91. This short call option will expire on Friday, April 9th.

At the moment, we are now in a strategy we call in-the-money covered call on Apple. Summarizing our current position:

1. Apple stock net purchase at $122.15, now valued at $125.66
2. Apple short call sold at $0.91, now valued at $1.73, a loss of $0.81
3. Adding 1 & 2, entry value is at $121.24, and closing value is at $123.93. The entire position is currently up by 2.2% (Buyers of shares would be up by 1.7% today, so we are now 0.5% ahead)

Now that we have changed strategies, we wait and see what happens. Another adjustment will be made if Apple somehow crosses the $127.5 mark before Friday; until then we sit on our hands and watch. We chose that number because that is where the 50-day moving average is.

Update (12.04.2021)

The trade was adjusted last week Friday, but I was unable to update the document because of the operational tasks following the closure of the Kudy Trust Fund.

Apple closed on Friday at $133.00. It blasted through the 50-day moving average of $127.70. We essentially just let the in-the-money covered call run its course. We ended up buying the $125 short call to close at $8.00. This dragged the performance of the stock, but that is part of our risk management. We gave up some upside in order to have downside protection. To summarize the position as at Friday:

1. Apple stock closed at $133.00
2. Apple short call closed at $8.00. Net loss of $7.09.
3. Net position (adding 1 & 2) = $125.91
4. Net profits now stands at $4.67 or return of 3.85% in two weeks (remember that our net purchase price was $121.24)

Ordinarily we would have closed this position on Friday because it has surpassed our target. We are targeting a return of 15–30% per annum, but this trade, when annualized, has come to 66.7%.

We were having so much fun we decided to extend the trade by one more week. This time around, we held on the shares, and then sold another in-the-money short call again. We believe that the market is too hot at the moment and is due for a pull-back. This may not happen right away, but we would be wary of jumping into stocks.

To continue with this trade, we need to add the loss made from the initial short call ($7.09) to the initial cost basis of the shares ($121.24). Our new cost basis is now $128.33. To check that this cost basis is correct, Apple closed at $133 and using this cost basis, we have a net profit of $4.67, which is in line with #4 above.

Like I said earlier, the market is too hot, so we went and sold another in-the-money short call at $130 (this short call will mature on Friday April 16th). We sold at $3.29 per share

As at today, we are now in this position:

1. Apple share with a cost basis of $128.33
2. Apple short call, sold at $130 for credit of $3.29

Footnote: as expected, the market has pulled back today, and the short call is now in profits. The strategy is paying off nicely. Remember: we don’t care what direction the market is going, we just want to make money.

For now, we sit and watch.

Update (17.04.2021)

And we closed the trade last night.

Apple stock closed at $134.16. The entire market was crazily bullish over the past two weeks, and anyone would have easily made money by simply buying the right stock. We ended up selling the stock at $130/share, while keeping a credit of $3.29 for the short call.

This is like selling the stock at $133.90. Our net profits in this exercise came to $5.57 or 4.3% over a three-week trade. So we set aside $127,500 to purchase 1,000 shares of Apple. We were able to generate profits of $5,570, or a net return of 4.3% over a period of three weeks. This is over our target return, as this annualizes to 74.5%.

Anyone who went directly to buy the shares would have made more money than we did because the market was super-bullish. No one can accurately predict what will happen in the market at any time.

Through this exercise, you will appreciate how we have been able to remove the element of luck from the trading process. Regardless of what happened, we would have looked for a way to squeak out some returns from the trade.

We hope that this exercise has been enlightening.