Here is a question we receive occasionally at Project Hedgehog:
“Is Project Hedgehog a barbell strategy?”
As a bonus topic for this week, let’s explore what a barbell strategy is and then we can answer the question as it relates to Project Hedgehog.
Pumping Iron
A barbell strategy is an investment approach that concentrates assets in two extremes: Risk-free investments and highly speculative ones. Like a physical barbell with weights only on the ends, this strategy avoids moderate-risk, "middle-of-the-road" assets that are commonly used.
This differs from the typical investor approach of buying broadly into the stock market which could be considered “middle-of-the-road” with moderate risk and moderate returns.
The goal is to balance stability & safety with high growth potential, ensuring that the safe side protects the overall investment while the aggressive side opens the possibility of significant upside.
The Safe End (85-95% approx.): The majority of the portfolio is placed in ultra-safe, liquid assets. This typically includes Treasury bills, high-quality bonds, or cash equivalents. This provides a "floor" that protects against a total market collapse.
The Risk End (5-15% approx.): The remainder is put into high-risk, high-reward assets. This could include startup equity, crypto, futures/options, etc. Since the exposure is small, a total loss here won't ruin the investor, but a "moonshot" success can significantly boost overall returns.
Barbell Example
Let’s say an investor feels really strongly about the growth prospects of XYZ stock. We can pretend that XYZ is a tech company that just went through an IPO. The company is considered to have huge upside potential, but also a great risk of losses. The market is not quite sure how to price the stock, and significant volatility in the stock price might occur in the future.
We can review two different approaches to investing in the company:
Option #1 - Buy XYZ stock directly and hope for the best!
Option #2 - Create a barbell strategy that will allow for upside gain if XYZ stock skyrockets, but protects our capital if XYZ tanks.
Let’s assume the following:
We have $100K that we want to invest for one year.
XYZ is current trading at $100/share.
A risk-free investment option exists that pays 4% per year (money market, 1-year U.S. treasury, etc.)
We want to review the extreme possible outcomes of XYZ losing half its value or doubling in the next year.
Here is our strategy for XYZ barbell investment Option #2:
Invest $90K in the risk-free investment that pays 4%.
Invest $10K in out-of-the money call options for XYZ.
We will assume that we can buy the $110-strike call option for $10/share (or $1K per contract).
How much money do we make or lose with each strategy if we get one of our two extreme outcomes?
The results for Option #1 are easy to understand. We double our money to $200K if the stock price doubles. And we lose half our money and end up with $50K if the stock price falls 50%. Nothing surprising here.
Option #2 has two parts. We put 90% of our money in the safe 4% investment. This causes our $90K to increase to $93,600 no matter what happens to XYZ stock price.
The other side of our barbell is our $10K worth of long call options. We purchased the $110-strike options for $10/share. If the stock price rises to $200/share, these options at expiration will have an intrinsic value of $90/share ($200/share stock price - $110 strike price for the option contracts).
Since we paid $10/share for the contracts and we can sell them for $90/share after one year, that represents an 800% gain! Our small $10K investment in these contracts turns into a $90K result. Adding this to the $93,600 result from the “safe” side of the barbell, we end the year with $183,600 with Option #2.
On the downside, if the stock ends the year anywhere below $110, then the options we bought are worthless and the $10K we invested in options is completely lost.
Here’s a summary of the extreme outcomes for each option:
We can now see that our barbell strategy offers significant upside if the stock rapidly increases due to the massive leverage we gain from employing call options instead of buying the stock outright. Option #2 gained nearly as much as Option #1 at the end of the year.
But on the downside, our barbell trade preserves the majority of our capital should the stock not perform well. We are mostly protected from a nasty downturn because we parked the majority of our cash in a risk-free investment. In the event of a 50% drop in the stock price, Option #1 loses $50,000 and Option #2 in aggregate only loses $6,400.
That’s the essence of a barbell strategy: We want exposure to the upside potential of a risky investment without the exposure to the downside.
Is Project Hedgehog a Barbell Strategy?
Technically, no.
We cover in great detail in our 17 Lessons exactly how and why Project Hedgehog investments counterintuitively can outperform the market by reducing risk.
But each investment choice stands on its own merit and we have no need for a “safe” side of the barbell because every Project Hedgehog position has a built-in hedge!
If you have any questions, please reach out to us:
Disclaimer:
All content on this website and email newsletters - including any discussions of specific investments, trades, or strategies - is for informational and educational purposes only and should not be considered personalized financial advice.
Investing involves risk, and you could lose money. Any investment decisions, trades, or actions you take are made at your own risk. Always conduct your own thorough research before making any investment decisions.
