Portfolio Tactics: Hedging Your Portfolio

Question of the Day

Daniel W., who has been a premium member for quite some time now, asked the following question:


" Hi Hamish, the tech stocks/NASDAQ just keep going higher, and valuations keep going higher to levels that seem unreasonable and that worries me some, but the market doesn't seem to care at this point. With hedges (via long-term puts) in place, I will feel more comfortable putting a higher percentage of my portfolio to work. "


It is indeed correct that hedging through long puts is a popular way of capping downside risk. Along with our other strategies, it's indispensable to creating a well-balanced portfolio that results in lower standard deviation and smaller positive correlation with the stock market. However, the return differential between buying insurance in every market environment and purchasing it selectively depending on the VIX levels is enormous. Let's dive into a study we've just finalized.


Hedging Study From June 2010 to June 2019

Continuously buying long-term puts on IWM

As can be seen from the graph, continuously buying puts to hedge a long stock portfolio hasn't led to a stellar performance despite frequent spikes in the VIX. Let's break this strategy down:

  • Buying an at-the-money put on the Russell 2000 ETF with 2.5 years to expiration

  • After one month, we buy back the put and roll out to a new at-the-money put to keep our short delta close to 0.50 (with the same duration of close to 2.5 years)

  • We are thus 100% of the time invested in long-term puts

  • The average cost of the long-term put over the past decade would have been $1100 per one lot

  • Cumulative loss would have amounted to $780 per ONE lot; hedging a larger portfolio would have been a costly adventure

(Source: Option Generator's Research)


Buying long-term puts on IWM when the VIX is below 17% (historical average)

Let's say that we only buy and roll out at-the-money puts when the VIX is trading below 17%. We only evaluate the VIX on the first day of the month and decide what to do. Should we consider

  • Rolling/buying puts (because VIX < 17%)

  • Selling our existing position (trade executed on the first day of the month, because VIX > 17%)

  • Doing nothing if there's no existing long put position (because VIX > 17%)

By strategically putting on a long put position, we would have been invested in this hedge 60% of the time. As such, there are several months during which our portfolio isn't sheltered from a possible correction.


In contrast to buying and rolling long-term puts every single month, we would have made a decent amount of money despite the massive bull run. These gains could have offset temporary losses on our covered call positions.

(Source: Option Generator's Research)


Conclusion

Buying puts is a popular way of hedging a long stock portfolio, but it only makes sense if we're not invested in this insurance 100% of the time. In high VIX environments, utilizing covered calls and other strategies that are non-correlated with the stock market are much better choices to offset long exposure.


In fact, as pointed out in many articles, in-the-money covered call writing is a great way of reducing standard deviation and correlation. There's only one caveat: we should always look for a decent initial option return to make sure that our chances of success are considerably high.

Option Generator AM

Company number: BE 0750.963.805

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