Market hedging methods

[hardincap]

For those of you who hedge against general market declines, do you prefer going long puts, short selling the index, or other, and why?

[LC]

I don't really hedge other than selling and holding cash, which is my preferred "method" because I think the call option on cash is valuable, but as a second option I think selling calls would be the best bet because you obtain the float up front. It's an insurance policy so you have to value it as such, and as any insurance policy it becomes more valuable if you have the solvency to weather intermittent volatility.

[randomep]

I don't really hedge other than selling and holding cash, which is my preferred "method" because I think the call option on cash is valuable, but as a second option I think selling calls would be the best bet because you obtain the float up front. It's an insurance policy so you have to value it as such, and as any insurance policy it becomes more valuable if you have the solvency to weather intermittent volatility.

 

sell calls against what? what you own?

 

And how much would you have to sell as a rule of thumb to protect $X of your portfolio?

[frommi]

Long puts when insurance is cheap. Shorting the index is emotionally a problem, i would rather sell all my holdings and go to 100% cash than to do it again :). In those two weeks i tried it more than half the time my longs and my shorts ran against me. So that gave me more volatility instead of less. And with a basket of shorts on overvalued stocks you have the same problem and a lot higher borrowing costs. Short calls can get you into the same emotional traps when you don`t hold the underlying and when implied volatility is low, the premiums are not worth it.

 

With puts your "problem" gets smaller in case you didn`t need the insurance, its a lot easier to hold onto the insurance. But its possible that this is only a personal thing. I would love to find a lot of overvalued stocks with implied volatilites below 20 but i have not found any. In the end i hedge with small positions in LEAP puts on BBH and SPY.

[Lance]

I like to go long puts on the Russell 2000 (IEM).  I'm long the Jan 2016 $115 and $120 strikes.  If the market continues to advance I will go long the $125's at some point.   

 

The only stock I'm short is NFLX at just over $430.  I've never been comfortable buying puts on individual names, but not sure why.

 

Thanks,

Lance 

[SharperDingaan]

For those of you who hedge against general market declines, do you prefer going long puts, short selling the index, or other, and why?

 

We hedge extensively, & pretty much the same way as LC.

Sale & repurchase of up to 50% of a holding has the advantage of capturing both downside, & downside estimation error (more valuable), & doesn't expose you to the risks of shorting. Reinvesting the proceeds in high quality corporate bonds also gives you liquidity, CF, & a 'flight to safety' gain on exit - to offset portfolio drag.

 

The cost is 4 commissions + possible loss on share repurchase - interest earned/saved(debt repayment) - flight gain on bonds. The benefit is the loss avoidance + possible short gain on share repurchase. Almost always, this is higher than the premium you might have earned had you sold calls instead. The major advantages are no requirement for an option market, & commission as a % of total transaction value rapidly declining as transaction size increases.

 

Were we institutional we would overlay a short benchmark equity index & long bond index.

 

SD

 

 

[ni-co]

I don't know what would have to happen that I'd go outright short anything. 100% if I am right, unlimited downside if I'm wrong? I never understood how you want to go short anything if you could just buy a put on it and only risk the premium. Usually, puts are expensive, though.

 

Whether I go into cash or puts depends on the price for the puts and my expected returns going forward. Momentarily, I decided to stay fully invested and to put about 4% of my portfolio into LEAP puts on CRM and IBB (on margin). This gives me a 10-15% "cash" cushion in case of a 50% CRM/IBB decline from current levels, while being a 2.5-3% performance drag (annualized) if I loose the premium.

 

Whether this is a good deal depends on the expected returns on my portfolio. A 10-15% cash position would be about the same performance drag if I expected my portfolio to make 15% per year. I expect higher returns, so I go for the options. There's a certain chance of winning on both ends and of course the risk of losing the premium while not achieving 15% on the long side…

 

What matters to me, though, is that I can't lose more than 4% of my portfolio on the short side.

[peter1234]

Interesting musings on using SPY Jan 15 Puts.

 

http://www.alphaarchitect.com/index.php?c=index&a=blogpost&preview=true&blogid=12126&p=12126

 

How much does it cost to ensure a 20% maximum drawdown? 60bps!

 

Top 30 drawdowns from 1927 through 2013 for the S&P 500 total return index. There are

• 8 episodes where drawdowns are over 20% and

• 14 times when the drawdown is over 10%.

 

BTW not sure if it lists all drawdowns >10%. For example, seems like 2011 and 2010 had drops > 10% as well.

[rayfinkle]

I buy puts on crappy overvalued companies with tough comps coming up. Target situations where returns are 3-4x my (capped) risk.

[anders]

My advise is a) you should start reading history of hedging to build your own info bank that suits you and your investing style.. From my experience, many know how to use hedges in theory but cant handle them in practice... b) hedging should be a strat not a thing one you do from time to time, then it becomes speculation... nobody knows market direction, so example shorting index cause you feel or think its overpriced is really difficult.. cisco went up 100x during IT bubble before reversal, think about those who were "hedging" the stock after it went 5x...c) i like to view hedging from a catastrophy macro level, example risk 1% of yearly performance for protection...example assets with great convexity.. d) Make sure you know the products you are investing in.. buying ie ETFs is most propably not a good way to hedge your portfolio...

 

I believe that the best way to hedge is to do your homework properly and buy your investment at a price so good that even a bad sale make a good result.. Thats your real h(edge)..  ;)

[ni-co]

Interesting musings on using SPY Jan 15 Puts.

 

http://www.alphaarchitect.com/index.php?c=index&a=blogpost&preview=true&blogid=12126&p=12126

 

How much does it cost to ensure a 20% maximum drawdown? 60bps!

 

Top 30 drawdowns from 1927 through 2013 for the S&P 500 total return index. There are

• 8 episodes where drawdowns are over 20% and

• 14 times when the drawdown is over 10%.

 

BTW not sure if it lists all drawdowns >10%. For example, seems like 2011 and 2010 had drops > 10% as well.

 

By the way this is for the January 15 puts. We have June now. And at least as far as I'm concerned it's only interesting to look at the hedging cost on a per year basis. The June 15 155 puts trade around $2.85 which is more like 145 bps.

[peter1234]

Interesting musings on using SPY Jan 15 Puts.

 

http://www.alphaarchitect.com/index.php?c=index&a=blogpost&preview=true&blogid=12126&p=12126

 

How much does it cost to ensure a 20% maximum drawdown? 60bps!

 

Top 30 drawdowns from 1927 through 2013 for the S&P 500 total return index. There are

• 8 episodes where drawdowns are over 20% and

• 14 times when the drawdown is over 10%.

 

BTW not sure if it lists all drawdowns >10%. For example, seems like 2011 and 2010 had drops > 10% as well.

 

By the way this is for the January 15 puts. We have June now. And at least as far as I'm concerned it's only interesting to look at the hedging cost on a per year basis. The June 15 155 puts trade around $2.85 which is more like 145 bps.

 

Agreed. Also, would be interesting to see the differences in strategies about buying/ rolling different maturities (say, 3 months, 6 months, 12 months, 24 months). When you need it, volatility will be higher and your cost will be higher for new positions at that time. This is where it gets complicated and expensive with Puts.

 

This is what makes Sharper's market timing methods of moving to cash attractive, simpler and cheaper. Except...

when and how much do you move to cash?

 

The Put buying strategy you would have to do continually (or above a certain Cape threshold for example) and just regard it as insurance you keep paying annually.

[SharperDingaan]

This is what makes Sharper's market timing methods of moving to cash attractive, simpler and cheaper. Except...

when and how much do you move to cash?

 

Lot simpler than you would think ...

- Prospects for significant dilution/BK 6 mo out? If not good - sell.

- What is your EMV for XYZ coy 6 mo out?  P(x) x Price(Optimistic) + P(y) x Price(Realistic) + P(z) x Price (Pessimistic)

- Higher than price today? Dont hedge

- Lower than price today? If there is a compelling reason to stay - 50% hedge; if not - sell & move on.

 

Just keep in mind that you are taking the long view, & coining it by market making against crowd sentiment & investment horizon.

As long as the underlying doesn't BK (ie: buy quality) you should essentially steam-roll to a successfull result.

 

Not textbook, & not what your advisor wants you to practice ...

 

SD

 

 

[peter1234]

This is what makes Sharper's market timing methods of moving to cash attractive, simpler and cheaper. Except...

when and how much do you move to cash?

 

Lot simpler than you would think ...

- Prospects for significant dilution/BK 6 mo out? If not good - sell.

- What is your EMV for XYZ coy 6 mo out?  P(x) x Price(Optimistic) + P(y) x Price(Realistic) + P(z) x Price (Pessimistic)

- Higher than price today? Dont hedge

- Lower than price today? If there is a compelling reason to stay - 50% hedge; if not - sell & move on.

 

Just keep in mind that you are taking the long view, & coining it by market making against crowd sentiment & investment horizon.

As long as the underlying doesn't BK (ie: buy quality) you should essentially steam-roll to a successfull result.

 

Not textbook, & not what your advisor wants you to practice ...

 

SD

 

Thank you, much appreciated.

:)

[dpetrescu]

["I would love to find a lot of overvalued stocks with implied volatilites below 20 but i have not found any."

 

I own soma CAT and RIO long term puts as insurance. I think these are very overvalued and have very low volatilities, one had less than 20 implied volatility when I bought it so premiums are very cheap.

[frommi]

["I would love to find a lot of overvalued stocks with implied volatilites below 20 but i have not found any."

 

I own soma CAT and RIO long term puts as insurance. I think these are very overvalued and have very low volatilities, one had less than 20 implied volatility when I bought it so premiums are very cheap.

 

Its hard to buy puts on these stocks when you expect inflation to come. :D

But the idea is not that bad, perhaps i should look at overvalued quality stocks like CL, CPB or HSY. But i doubt that the puts are cheaper than the SPY puts. (Just checked, no they are not cheaper.)

[peter1234]

Damodaran has a good post on Market Timing

:)

 

http://aswathdamodaran.blogspot.ch/2014/06/bubble-bubble-toil-and-trouble-costs.html

 

Monday, June 16, 2014

 

Bubble, Bubble, Toil and Trouble: The Costs and Benefits of Market Timing

If you believe that the stock market is in a bubble, you have lots of company. You have long-time market watchers, the New York Times and even a Nobel Prize winner in your camp. But what exactly is a bubble? How can you tell if you are in one?  And if you do believe you are in a bubble, what is your best course of action? Not only are these questions difficult to answer, but the answers can vary across markets, investors and time.

 

 

Doing nothing is often the best response to a bubble: The most rational response to a bubble is to often not change the way you invest. If you believe, as I do, that it is difficult to diagnose when you are in a bubble and if you are in one, to figure when and how it will dissipate, the most sensible response to the fear of a bubble is to not change your asset allocation or investment philosophy.

 

Conversely, if you feel certain about both the existence of a bubble and how it will burst, you may want to see if your certitude is warranted given your metric.

[Lance]

Great thread, I've really enjoyed the comments.  If you were expecting a broad market decline between now and the end of October and wanted to hedge during the next few weeks, how would you go about it?

 

I'm currently holding (i) IWM Jan 2016 $115 and $120 puts, (ii) EEM Jan 2016 $38 puts, (iii) SLV Jan 2016 $25 calls & Jan 2016 IAU $16 calls, and (iv) am short NFLX and TSLA. 

 

Thanks,

Lance