And if a true market crash occurs, valuations will likely go substantially past fair value before prices eventually bottom. High valuations can persist for longer than anyone thinks possible. What about using a valuation filter and only hedging if stock valuations are high? One portfolio below applies the 2.5% quarterly budget 10% OTM hedge when CAPE is above 25, otherwise it’s 100% long SPY. Two, seemingly high implied volatility (like a spot VIX of 30 in September 2008) sometimes ends up being cheap relative to future realized volatility. One, low volatility can persist for a long time. There are two issues with this filter approach. But the filter did help a bit since 2013. The volatility filter underperformed the constant hedge during the financial crisis since spot VIX was well above 15 when markets crashed. When spot VIX is > 15 the hedge is not used and the portfolio is 100% long SPY. This isn’t a cherry-picked number – it’s just a simple level that I think most would consider low volatility. The graph below shows the 97.5% SPY and 2.5% budget 10% OTM hedge from above, and then a version where the hedge is only used if the prior quarter’s closing spot VIX value was less 15. For example, a popular argument is “volatility is low, hedges are cheap, so buy some puts”. Some investors think hedging isn’t suitable for all market environments, but rather only when certain criteria is met. Sources and Disclosures Hedging Based on VIX ![]() Here’s how each structure and budget did in those years. A 5.0% hedge budget in 2013 was evaporated each quarter, translating to a cumulative -20% annual drag compared to a 100% SPY position.Ģ008 was the ultimate year to have a hedge, 2013 was the opposite with SPY rising more than 30%, and 2018 was an in-between year with substantial volatility but only mildly negative SPY performance. Especially if a year is a steady grind higher like 2013. Seemingly small hedge amounts can translate to drastic underperformance in strong markets. Same data but for the 5.0% hedge structures. The chart below shows the differences in annual performance between the 2.5% hedge structures and a 100% long position in SPY. This table shows the cumulative CAGR and max drawdown data for all structures and allocation amounts since April 2007. ![]() The graphs below show the same structures as above, but for a target quarterly allocation of 95% in SPY and 5% in the hedges. Markets are mostly efficient – after the 1987 crash traders have bid up the implied volatility of distant OTM puts (well beyond what Black-Scholes would suggest) to reflect the fact that tail risks do occur and stock market returns are not normally distributed. The main takeaway of the above chart is that the strike distance doesn’t really matter. For example, if at the end of a quarter the SPY allocation drifts to 99.0% and the hedge is 1.0%, the percentages are rebalanced to 97.5% and 2.5%. ![]() The first graphs show the compound return and max drawdown for a 2.5% allocation to the three structures. April 2007 is the start of my dataset and this 11-year period captures a full recession and expansion market cycle. Data in this post ranges from April 2007 to December 2018. The old $235 put would be rolled to a new $245 put, with a new six month maturity and adjusted strike price. Then at the end of Q2 on, SPY was trading at $271.28. For example, on, the expiration would be used for the next quarter. This rounding is done to use more liquid strikes.Įach option originally has six months to maturity. The closest strike interval of 5 was $235. An exactly 10% OTM price would be $236.84. For example, on (end of Q1) SPY closed at $263.15. Options are rolled on the last trading day of each quarter based on the nearest SPY strike interval of 5. The data in this post covers three types of hedge structures: 10% out-of-the-money (OTM) puts, 20% OTM puts, and 30% OTM puts. Being long a put option offers limited downside and unlimited upside, but this attractive payoff profile comes at a cost since traders are (mostly) smart and price options accordingly. There are many ways to hedge, and a common method is to overlay SPY puts to protect existing stock exposure. Interest in hedging strategies tends to increase as market volatility rises. ![]() But has it actually worked? This post examines the historical costs and benefits of hedging stock exposure with SPY puts.
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