SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Should You Hedge or Diversify?


Using the most popular S&P 500 ETF (SPY) to represent the US stock market, this article will look at different ways to manage equity market risk using historical ETF and options data from ORATS Wheel since 2007. We will analyze the following unhedged, hedged and allocation choices:

  1. Unhedged exposure to SPY.
  2. Fully hedged exposure with at the money puts.
  3. Partially hedged exposure with out of the money puts.
  4. And a more simple approach of reduced allocation to SPY with the proceeds allocated to an intermediate term US Treasury ETF (IEI).
     

In the following data, I’m showing the hedged portfolios compared to the stock/bond portfolios scaled to have similar volatility. The option hedge parameters entered into the ORATS backtester targets the contract closest to one year from expiration and rolls the contracts at 45 days from expiration. The idea of going further out in time and rolling prior to expiration is to reduce the impact of negative theta (time decay) that you experience with long puts. I did not attempt to optimize the parameters that would result in the best hedging results. With the stock/bond portfolios, rebalancing is assumed to occur based on 5/25 rebalancing bands that can be replicated using Portfolio Visualizer and all results include the reinvestment of dividends. Past performance doesn’t guarantee future results. Now to the data.

 

1608471669_ScreenShot2020-05-11at10_41_50AM.png.f9a337da70958ab6e26d0044dc380029.png

 

What we see is not surprising based on published research I’ve reviewed from multiple sources. Hedging with puts has been documented to be inefficient due to the volatility risk premium (VRP) built into option prices, making it more effective to simply lower equity allocation and use the proceeds to buy safe bonds (IEI).  A stock/bond ETF or mutual fund portfolio is also much easier and less costly to manage. If buying puts produces poor long-term risk-adjusted results, it then means that selling them may produce attractive long-term risk-adjusted returns. That is the strategy we attempt to capitalize on in the Steady Momentum PutWrite service.

 

In the AQR podcast episode “diversify or hedge?”, the hosts discuss how a portfolio of equities and cash (or safe bonds, as in my example) produces better long-term results than hedging with puts. AQR also has a research paper titled, “Pathetic Protection: The Elusive Benefits of Protective Puts” which concludes that “because of path dependent outcomes and option expensiveness, put options may do more harm than good.

 

An alternative approach to protection that investors can take is increasing diversification. ”Hedging with puts" can still be a rational decision if an investor wants to protect from a near or complete loss of value in the stock market (and is willing to pay for it), at which point the outcomes would favor the hedging approach as opposed to the stock/bond approach. The goal of this article is to simply make investors more aware of the different choices they can make with regard to risk management and the expected outcomes related to those choices.

 

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.


Related articles

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • The Big Loss

    At his blog, Joey offers his perspective on the top reason that so many trader wannabes are not, and will not, become profitable traders. His post is titled: Learn to Lose Money to Make Money. Here are the Excerpts from the blog.

    By Mark Wolfinger,

    • 0 comments
    • 260 views
  • ETF Vs. Stock: Note Down the Vital Points

    Today’s small investment can fulfill your dream of high living tomorrow. But investing blindly can make it reverse. We all want to get a high return on our investment. Stocks or ETFs can be the best option for you in such cases. The investment in stocks or ETFs is not very different except few noticeable points.

    By Kim,

    • 0 comments
    • 292 views
  • Considering Trading? Here Are Some Trading Options You Need To Know

    Whether you are considering dabbling in day trading or looking for a longer-term investment if you want to start trading it will serve you well to carry out a little due diligence in advance. There are a number of markets that you could use and understanding how each one works and what they are all about is key.

    By Kim,

    • 0 comments
    • 5,875 views
  • Why Should You Paper Trade Options

    In my previous article I shared some thoughts why I believe traders should start with paper trading before committing real capital. Not everyone would agree, but today I would like to share another article by a trader I respect very much. The original article was published here

    By Kim,

    • 0 comments
    • 295 views
  • Is Long Call Better than Bull Credit Put Spread?

    The trigger to this article was a question posted on the forum: "why we should use bull credit put spread when you can just long call they both have limited loss both in long call you have unlimited profit why limited it with bull put spread?" You can read the discussion here.

    By Kim,

    • 0 comments
    • 446 views
  • Strike Selection: A 'Sweet Spot' for Option Sellers?

    The words above are powerful because they're approach-agnostic. It doesn't matter if you're an old-school pit trader who swigs grit instead of coffee before the opening bell, or a Gen Y technocrat who codes trend-detection algorithms. All traders live and die by The Four Words. If you consistently buy low and sell high, then you will be profitable.

    By Kim,

    • 0 comments
    • 1,558 views
  • Post-Earnings Implied Volatility Crush

    Earnings crush is the fall in implied volatility after earnings is announced. Typically, earnings announcements cause the price of the stock to move more than normal. The move will have more effect on short dated expirations since the day of earnings large move has more weight than the rest of the days with normal moves. 

    By ORATS_Matt,

    • 0 comments
    • 352 views
  • Why Not to Hold Strangles Through Earnings

    In my previous article, I described a strategy of buying strangles a few days before earnings and selling them just before earnings. In this article, I will show why it might be not a good idea to keep those strangles through earnings.

    By Kim,

    • 0 comments
    • 387 views
  • How to Prepare for Crypto Downturns

    Most cryptocurrency owners skipped a heartbeat when the bitcoin fell to 50% from its all-time high. According to experts, such nasty downturns are natural, and the crypto market may witness such downturns now and then.

    By Kim,

    • 0 comments
    • 520 views
  • Tradier Brokerage Special Offer

    Tradier Brokerage is partnering with SteadyOptions to offer a special promotion for SteadyOptions customers: Open an account with Tradier Brokerage and get no subscription fees for 3 months, plus all ACAT fees will be waived. After opening an account, you will also receive 3 months of free access to TradeHawk, our full-featured customizable trading platform.

    By Kim,

    • 0 comments
    • 662 views

  Report Article

We want to hear from you!


Thank you @Jessefor another great article.

How about trying to combine two approaches: hedge but replace SPY with naked puts? If you sell the puts slightly ITM (maybe 1%) every month, you should still keep some nice upside in case SPY rallies, get some premium to pay for the long puts, without sacrificing returns? Kind of a mix between Anchor and Momentum.

Share this comment


Link to comment
Share on other sites
On 4/24/2020 at 3:40 PM, Kim said:

Thank you @Jessefor another great article.

How about trying to combine two approaches: hedge but replace SPY with naked puts? If you sell the puts slightly ITM (maybe 1%) every month, you should still keep some nice upside in case SPY rallies, get some premium to pay for the long puts, without sacrificing returns? Kind of a mix between Anchor and Momentum.

 

Using ORATS again, this is what a combination of a 55 delta short put and 30 delta long put looks like since 2007:

CAGR: 3.5%
Volatility: 6.13%
Max DD: 12.82%
Sharpe: 0.57

Share this comment


Link to comment
Share on other sites
11 minutes ago, Kim said:

Not very encouraging..

 

There may be better parameters to run the long put hedge. If you want me to test any other combinations of entries and exits for the hedge, I'm happy to do so. For example, shorter or longer DTE entries as well as exits. A 365 DTE entry and 45 DTE exit made sense to me for managing the negative theta, but there might be different parameters that work better. Tradeoffs to everything, of course.

Share this comment


Link to comment
Share on other sites

What I'm doing for my personal portfolio is the following:

  • Selling SPX puts one month out around 1% ITM
  • Spending 1% of the portfolio on cheap OTM puts (around 2-3 delta) spread over 6-24 months

During the current meltdown, the long puts provided me a very protection dues to the fact that VIX exploded to 80+. I'm not sure how easy it is to test it..

Share this comment


Link to comment
Share on other sites

They say "We find that if your view is for a large and systemic selloff—greater than what is priced by the market— then a volatility-based hedge can potentially make more sense. For smaller and more-fundamentally driven selloffs, directional hedges via equity options may be the more appropriate choice."

Share this comment


Link to comment
Share on other sites

@WayneCthanks for the links, great resources.

I actually looked into VIX calls and compared them to far OTM SPY puts. I looked at the approach of 50 cents trader. Take a look:

https://www.cnbc.com/2018/02/12/the-mysterious-trader-nicknamed-50-cent-made-200-million-last-week-as-the-market-blew-up.html
https://www.reuters.com/article/us-usa-stocks-volatility/big-volatility-options-trade-points-to-mystery-investor-50-cent-idUSKBN1ZS0HW

The strategy involves buying next month OTM VIX calls around 50 cents. 

It paid of very well in the last crash, but the crash was very sharp and quick, and VIX reached 80+ in a matter of few weeks. In case of more gradual decline, the hedge would be less effective, and after the initial decline, the following months VIX futures will become very expensive and not economical for hedging.

Of course you can spread the hedge over few months, but the following months become too expensive. For example, under "calm" markets (VIX in low teens) you can buy the following month 25 calls for 50 cents. But if you go 6-9 months out, then to spend only 50 cents you will need to go up to 40-45 strike.

But maybe some mix of SPY puts and VIX calls can make sense.

Going back to the article, if we take the current crash, we can see that hedging (as represented by our Anchor strategy) worked better than diversification (as represented by Steady Momentum strategy), at least so far. Both strategies reduced portfolio volatility, but Anchor was actually up at some point in March when SPY was down 30%+. @Jesse would you like to comment?

Share this comment


Link to comment
Share on other sites
On 5/2/2020 at 7:19 AM, Kim said:

@WayneCthanks for the links, great resources.

I actually looked into VIX calls and compared them to far OTM SPY puts. I looked at the approach of 50 cents trader. Take a look:

https://www.cnbc.com/2018/02/12/the-mysterious-trader-nicknamed-50-cent-made-200-million-last-week-as-the-market-blew-up.html
https://www.reuters.com/article/us-usa-stocks-volatility/big-volatility-options-trade-points-to-mystery-investor-50-cent-idUSKBN1ZS0HW

The strategy involves buying next month OTM VIX calls around 50 cents. 

It paid of very well in the last crash, but the crash was very sharp and quick, and VIX reached 80+ in a matter of few weeks. In case of more gradual decline, the hedge would be less effective, and after the initial decline, the following months VIX futures will become very expensive and not economical for hedging.

Of course you can spread the hedge over few months, but the following months become too expensive. For example, under "calm" markets (VIX in low teens) you can buy the following month 25 calls for 50 cents. But if you go 6-9 months out, then to spend only 50 cents you will need to go up to 40-45 strike.

But maybe some mix of SPY puts and VIX calls can make sense.

Going back to the article, if we take the current crash, we can see that hedging (as represented by our Anchor strategy) worked better than diversification (as represented by Steady Momentum strategy), at least so far. Both strategies reduced portfolio volatility, but Anchor was actually up at some point in March when SPY was down 30%+. @Jesse would you like to comment?

 

I'm waiting for a response from Matt at ORATS about a question related to the backtesting output...I've found a discrepancy that doesn't make sense to me, and might be causing the backtest to be displaying results that are worse than they should based on if you enter the backtest as a "married put" strategy vs. a "protective put" strategy. I backtested based on "married put", but if I change it to "protective put", the results are much better for the hedged strategies. If that turns out to be true, I'll need to update the article with corrected numbers, but until I hear back from Matt I'm not sure so we'll have to standby.

Share this comment


Link to comment
Share on other sites
On 5/4/2020 at 10:17 AM, Jesse said:

 

I'm waiting for a response from Matt at ORATS about a question related to the backtesting output...I've found a discrepancy that doesn't make sense to me, and might be causing the backtest to be displaying results that are worse than they should based on if you enter the backtest as a "married put" strategy vs. a "protective put" strategy. I backtested based on "married put", but if I change it to "protective put", the results are much better for the hedged strategies. If that turns out to be true, I'll need to update the article with corrected numbers, but until I hear back from Matt I'm not sure so we'll have to standby.

 

I've updated the data in the chart based on discussions with ORATS to make sure the backtest is being simulated properly. The hedged portfolios now looks better than before, although still less attractive on a risk-adjusted basis relative to stock/bond portfolios that have been scaled to have the same volatility as the hedged portfolios. The hedged portfolios also don't factor in the cash outlay required to buy and roll the hedge, so this essentially simulates buying the puts interest free on margin. If that were properly accounted for, by either deducting applicable margin interest, or if not using margin reducing the quantity of SPY, results would be slightly worse than shown.

Share this comment


Link to comment
Share on other sites


Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido