Hedging is Dangerous to your Portfolio
In the comments of Dave’s post about a hypothetical system that buys after 8 straight down days, the idea of adding some short positions based on the opposite criteria (8 straight up days) as a “hedge” was mentioned. Dave’s followup post showed that following the reverse criteria was not a profitable strategy but I wanted to address the idea of hedging a mostly long equity swing system in general.
I’ve spent literally thousands of hours evaluating (and trading) different swing trading strategies, from entries, exits, position sizing to maximizing the ratio of average return vs max drawdown. I can say with a fair degree of certainty, that if there is a hedging strategy that increases the risk/return ratio of a successful long swing portfolio, I have not seen it. What usually happens is that a hedge only succeeds in limiting your upside while potentially increasing your actual risk.
For example, lets say that for every 10% of long exposure, the system adds 5% of short exposure, thus allowing for a maximum of 150% exposure with 100% of that long, 50% of it short. The idea behind this is that by shorting stocks likely to go down, you are gaining protection against a steep drop in the market while you are most exposed on the long side. The problem comes in implementation.
- The nature of Dave and I’s style of swing trading is that we’re buying stocks on short term weakness (ie Dave’s 8 down days). Since the overall market plays a large role in an individual stock’s movement, it means that our long exposure will be highest when the market is short term oversold, which is when you want to be adding longs, not shorts since the reversion to the mean move is much more likely then the explosive breakdown.
- Potential upside is significantly reduced. Since exposure is added on short term market weakness, a large move up in the market (which is where most of the individual equity profits come from) will most likely cause the shorts to go up too, thus reducing your profits.
- The shorts do not protect you at all from the largest risk in swing trading, which is individual company risk. Market crashes are few and far between, stocks gapping down 10-20% due to earnings/news are relatively common. No amount of shorts helps when 2 of your swing holdings both have bad earnings on the same day.
A second common strategy is to buy puts on an index (ie S&P 500). The problem with this strategy is that by using options to reduce your risk, you’ve introduced two additional variables into the equation, time and a predicted price. Each put you purchase loses value each day you own it. The closer the expiration the put is, the faster it loses value. This leads to inclination to buy further out options to reduce the cost of time decay. However, once you move more then a month or two out, how do you pick the strike price? If it’s Jan 15 and the S&P is at 1400 and you buy a May 1400 put. The S&P could slowly increase to 1500, by the end of April, then plummet 75 points in a single day, yet your put is till 25 points out of the money since the index moved so far prior to its plunge. Also, even in the case your put does become “in the money”, when do you sell? Wait too long and the index might rebound leaving your put worthless, sell too soon and you’ve significantly reduced the amount of protection you received from the put.
With both the above strategies, what it comes down to is this. If you have a successful shorting strategy, run it as a separate system. Don’t tie entries in one system to entries in another. Just because you increased your long exposure 30% today doesn’t mean you have to add a short. Same with the options. If you have a successful system for trading S&P options, by all means use it, but don’t tie that to your long equity purchases. You’ll only harm both of their performances.
The only way to actually have protection in a long only swing system is with position sizing. It is imperative that each position be small enough that a 20% gap down does not destroy your portfolio, yet large enough that you’re able to benefit from a healthy move up. Obviously ideal position size will vary based on risk tolerance, but to give you a general idea, something in the 5-15% range would be reasonable. Even a 20% decline on a 15% position is only a 3% drop in total portfolio equity, easily recoverable. But a 20% decline on a 40% position is 8%, much more difficult to recover from.
Please feel free to comment with any additional hedging strategies I did not cover.
- John
Wednesday, April 4 11:12 pm
I agree with what you say, but there may be confusion with some between hedging and running different systems that trade non or negatively correlated assets. I think you did spell it out but it can be a subtle point.
Personally I believe hedges are best for long term holdings that you may not wish to sell for tax or dividend reasons. In that that case short term index hedges can offer a measure of protection.
Thursday, April 5 10:31 am
I think BriG has it exactly right - I use hedging for my long-term taxable portfolio when I believe the market is overbought. This allows me to hedge the whole book at selective points in time while avoiding tax consequences. I agree, however, that options are not the way to do it. I think futures are the best way as they tie up the least capital, and are not subject to premium decay.
With regard to the 8 day system outlined - I was just curious if it provided anything meaningful on the short side as it did on the long side. Specifically, I was talking about the situation of prop trading - where you are generally leveraged anywhere from 5-20x your capital. In this case, a hedge is almost required to sleep at night, and may, in fact, be required by the firm in order for them to sleep at night. Having a 100% long portfolio in these situations is a bit too scary. Having said all that, it’s pretty clear the system would not work.
In general, if you are swing trading (holding periods of 2-10 days in my view), then hedging may, in general, hold little to no value as you are really riding the general wave of the market. Position size (either volatility or stop-based) are the most effective tools, imho, in swing trading.
Shorting, in general, is much, much tougher than it used to be due to the influx of cash from hedge funds (which, with $2 trillion dollars under management not counting leverage) and private equity. If we were to assume that 25% of the $2 trillion is allocated to long/short funds ($500b) and then assume that 25% of that is allocated short, that is $125b in shorts that didn’t really exist 10 years ago. Add leverage and it is even larger. Combine this with private equity taking out companies at high valuations due to huge allocations to the category, and the retirement of enormous amounts of equity via buy-backs, and the short game, imho, has never been harder.
Comments welcome!
Thursday, April 5 10:42 am
BriG,
You actually wrote what I was going to say in a followup post, that hedging is not the same as running uncorrelated systems. There is obviously _significant_ benefit in combining multiple independent systems in a single portfolio, even if some of them individually are not stellar performers they can lead to a much more attractive equity curve. What I was arguing against was forcing an entry in a secondary system because of what was happening in the primary system.
John
Thursday, April 5 10:58 am
I would also add that a great way to combine systems is to have different timeframes for systems. So, a day trading system, a swing system and a long term system rather than thinking of separate long/short systems.
Thursday, April 5 11:09 am
Damian,
Couldn’t agree more with everything you said, especially with regards to shorting.
As far as prop trading, I don’t think the type of swing trading Dave and I were discussing is well suited for prop trading. Even using only 5x your capital, a 10% dradown is 50% of your starting capital. That’s just a recipe for disaster.
- John
Thursday, April 5 11:45 am
Great point Damian. Different timeframes and system types are a great way to combine systems. I actually do that in my own portfolio, I combine my swing system with a longer term ETF system and then I sometimes do some intraday emini trading. 3 different systems, 3 different timeframes, somewhat independent results.
Thursday, April 5 11:55 am
I have a friend who trades at a desk with a small cap value approach using 10x leverage. Insane, in my view, but he does it very, very well. But he has to spend an enormous amount of capital hedging his book via options in order to not have heart failure on a daily basis. Remember, he’s trading small caps where you have 10-14% up and down days and spreads of 10 cents. He’s insane, but also an insanely great trader. I do not have the kind of stomach!
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