Hedges on the right path

Backtest Notebooks

A funny thing about relative performance is that you can win but still lose money.

Beating the benchmark is great, but investing is also about producing returns. Absent the conviction to pour your life savings into a single asset (looking at you Bitcoiners), most people hedge their bets. This takes the form of diversification both within asset types (low fee ETFs) and amongst asset classes (bonds, real estate, etc.)

As options traders, we know that the hedge can also be a derivatives position. Diversification is about smoothing out the choppiness and risk management - both qualities that you can achieve with an options structure.

While an overlay like the GULL isn’t meant to be a complete replacement for overall portfolio diversification, it can help achieve many of the same objectives. Rather than put a 11% CAGR and 17% vol product (SPY) into your efficient frontier calculation, you can optimize against your tokens and landlord headaches with a 8% CAGR, 8% vol product.

At the portfolio level, diversification works in mysterious ways. Bonds are supposed to be a hedge for equities - when stocks go down because people are panicking, there is a flight to quality with bonds. That’s not always the case, as we saw in 2022. Equities and fixed income can get crushed at the same time if the market is coming off a decade long ZIRP bender.

But even within structures that are designed to be rigid and offsetting like equity overlays, there can be some quirks to how the performance shakes out. Fortunately, this generally goes in the investors favor when you’re working with the equity risk premium.

The GULL is designed to buffer the downside in exchange for short call exposure. This should lower performance on the upside, but outperform in down markets. We expect to see positive return differentials when the market is down. But with just the right timing, it can even outperform in other scenarios.

This week in Backtest Notebooks, we’ll break down some specific examples for how if the timing lands just right, a hedged position can actually be a double winner - outperformance and gross returns.