When hedges buy the dip
Backtest Notebooks
It’s a truism of markets that when a hedge is working, you’re probably losing money.
A good hedge will do its job by offsetting losses in your primary position. Ideally it’s zigging while the other is zagging and vice versa, otherwise you end up with the dreaded double loss. If you try to get too fancy with correlations or complex positions, this is likely to happen.
But good hedges can have a silver lining, and that’s one of the attributes of a hedged equity position. A direct overlay on the underlying, it has predictable outcomes at every price point. Most of the performance but a lot less chop, along with offsets that credit dollars to your account.
When and how much of the performance you sacrifice will depend on the path the underlying takes. Even when you judo your convexity into a protection/participation combo, other than total destruction, the trade’s second most painful scenario is when markets rip faster than usual and you miss compounding.
But when the hedge performs, your portfolio is doing much better than the benchmark and you have an interesting choice to make. Sure you’re still in a loss scenario, but assuming the common structure of 5/20% protection, when the market is down 10% in a quarter, you have 5 points on the competition. And you’ve got cash.
During the trade window, that protection will behave variously depending on time to expiration. As with any put spread, so long as there’s time on the clock and not very deep in the money, it won’t reach its maximum value. The put spread is long vega, but short skew, so there might be some minor vol effects too.
The final offset comes when all the options expire. Since you paid $0 up front (from a short call exposure), you can close out or exercise the difference between long put and stock. The key here is that from a ledger perspective you’re only down that 5% buffer level, but your assets are in a mix of cash and equities now.
Cash is useful!
Today in the Backtest Notebooks, we’ll look at the impact of using cash from hedged equity to compound into stock purchases.
But before that, I have an offer. We’re going to continue talking about the GULL structure for hedged equity.
And I want to hear your questions.
Check out the free post below, and message me a question or post in comments, I’ll give you a free month’s subscription.
Also, I’ll select the best question from the lot and do a full post about it. If that’s you, you get a year long free subscription.
Happy Trading.
If you’re truly bullish, you’re unlikely to have much cash sitting around. Paychecks, bonus, inheritances, they’re all going into the market. The dip buyers aren’t the perma-bulls, unless the timing is just right.
Besides just the smoothing of ups and downs, hedged equity preserves value by giving you dollars when the stock prices drop. If those dollars are used to buy shares, the strategy has a built in feature to compound when markets are lower.
It’s also worth noting that the strategy must also sell stock when the market goes higher. Unless you’re borrowing money or putting in extra funds, a rising market requires you to either buy back short calls, or let exercises happen and buy in fewer shares at a higher price. In this 7 year period, compared to 9 dip buys, you’re making 15 rip sells.
Given that, and the mildest of inklings of what the market has done recently, you’ve already guessed how this could improve hedged equity strategies.
If you don’t use the cash to buy additional shares, it will come in handy down the line. Even saving up from when your hedge paid, you still burn through the cash quickly as indices head back north, and you’re back to selling shares.
The COVID crack in the first half of 2020 provides an illustrative example. In March, April, and May of that year, the HoldCash strategy quickly picks up greenbacks. What starts as 5% cash becomes 20% cash by May. But as the market whips back, you’ve spent all your hedge cash by December, and are selling shares in January 2021.
Even if you’re dip buying, the speed of the reversal quickly turns your share count around. While the first half of the year has you accumulating up to 15% more shares by May 2020, you’ve sold them all out by August.
The chart below assumes a $1M portfolio in SPY, tranched over 3 months, with a 5/20% hedge applied. Minimum cash balance is 5% of the portfolio.
So how well does all the clever dip buying work? We have two comparisons- against the basic vanilla underlying strategy, as well as the HoldCash.
In the table below are the comparisons for starting this strategy in January 2018. Returns are the annualized figure and volatility is the standard deviation of daily returns. Figures are presented relative to the benchmark of an all equity portfolio.
They’re different from the underlying in similar ways. Returns are a little better for the dip buyer, but it comes with a tad bit more volatility and drawdown. Net it has a higher Sharpe ratio, with reward outweighing risk.
In absolute figures, all three scenarios are shown below. It’s important to remember the power of compounding growth - 3 points more of annual returns gives you a 21% higher balance after 7 years with DipBuy vs. EquityOnly. ($2.19M vs. $1.8M on $1M starting portfolio).
The benefits of hedged equity appear not with the absolute returns, but with the drawdown figures. Cutting that value in half is very desirable. And on a day over day basis your position is going to move a lot less. It’s there when you need it. Dip Buying gets you a little closer to the equity benchmark, but it’s still very much a hedged equity experience.
As with all strategy implementations, there’s an interesting rubber hitting the road strategic decision to make - do you rebalance the options positions as your underlying position changes? That is to say, with multiple months, even if the position is split evenly to begin with, when you sell or buy shares impacts how much of a hedge you need at each roll period.
Simplest (and what is done here) is to setup the new 3 month options position to flatten the overall share position. This creates some relatively significant imbalances. When you make that first big buy in March 2020, the new month has 16 contracts compared to 7 in the front month, exacerbating an earlier imbalance. On average you’re 3 contracts max to min on a 10.5 contract average position size.
I haven’t done the specific testing, but the point of the above is not that you need to start doing all kinds of time spreads to smooth your position. You could, but you’re taking liquidity, so there will be a price for it. My hypothesis would be that the smallest benefits aren’t worth it, and mostly attributable to randomness.
Even zooming back out, the extra effort of doing buybacks does yield returns as you’d expect on an appreciating asset, but because of the overall position setup you still sell out the gains quickly. 74bps of CAGR gets you $84k more at the end. A nuance within the domain of hedged equity, rather than distinctly different return structure.
If you’ve gotten to this point of detail in a hedged equity strategy, the questions become meta. As the markets are dropping and you’re getting paid on put spreads, how much better does it feel to have 20% cash in your portfolio versus 5-6%? The absolute answer is you make more money on all equities anyways, so why are we splitting hairs here, but it all depends on what you want the future to feel like.