Portfolio Hedging using VIX Calls Explained

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VIX Futures and Options: Pricing and Using Volatility Products to Manage Downside Risk and Improve Efficiency in Equity Portfolios

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Top 3 hedging strategies: how to hedge your portfolio with CFDs?

What is a ‘hedge’? Simply put, it is a trade, or an investment, designed to mitigate risk. Therefore, ‘hedging’ is a process of reducing the risk by means of investments.

Hedging explained

Considering the wild ride traders faced in 2020 due to extreme market volatility, many are searching for effective hedging strategies to reduce risk and keep their finances safe.

So, what hedging techniques can the average trader employ without overcomplicating their trading strategy, while managing their trading budget?

All in all, hedging is an effective risk management tool, used by traders and investors to protect their funds against adverse market movements. It can be compared to insurance: you won’t prevent an incident from happening with a hedge, but hedging will limit the amount of damage done, if and when it actually happens.

Why do we hedge?

Hedging usually takes the form of holding several positions at the same time with the aim to offset any losses from the one trade with the profits from the other.

When you hedge, you do not think of generating profit, but try to find a proper way to minimise your loss. Actually, there is no a perfect means to prevent the market’s unfavorable movement against you, but a successful hedging strategy may significantly reduce your losses.

You should also carefully consider how much money you have available for hedging, as you need additional capital to place additional (hedging) trades. There is no singular answer to the question “How much should I hedge?”, because every trader has a different risk tolerance and funds available.

Why do we use CFDs for hedging?

Hedging can be performed through various financial instruments, however, derivatives, such as Contracts for Difference (CFDs), remain one of the most popular hedging tools among investors and traders alike.

CFDs are very flexible

Choosing contracts for difference, you can go long or short, and hedge yourself against any risk, regardless of the market’s direction

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CFDs require small initial deposits

CFDs are leveraged products, meaning that you have to deposit only a small part of money to place a trade, the rest will be covered by your CFD broker.

Unlimited access to different markets

Ultimate CFD trading platforms offer you an extended range of different markets available to trade. You can choose from a great variety of commodities, indices, stocks, currencies and cryptocurrencies, and will have no trouble finding a hedge.

Foreign exchange hedging

Many traders used to hold shares in the European and American markets. However, what happens if the CAD or AUD strengthen? It may be a good hedging strategy to use foreign exchange CFDs to reduce the impact of currency fluctuations on your portfolio.

Historic oil price drop
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The list of the most traded currency pairs as of 8 January 2020

Commodities have always served as effective hedging instruments. The thing is, the intrinsic value of commodities is independent from currencies. Even when a particular currency falls during a period of inflation, commodities often hold their value.

Let’s assume you hold shares in some of the world’s largest mining companies. You consider them a great long-term investment, however, you’re a bit nervous about short-term price drops. In order to hedge your investment, you can short-sell gold, oil or iron CFDs to constraint this short-term effect on your portfolio.

The list of the most traded commodities as of 8 January 2020

Stock market hedging

Well, imagine you own shares in a range of international companies. You believe they are good investments in a long perspective. However, the stock markets may be extremely volatile and you want to protect your capital. CFDs on indices are just what you need. Shorting CFDs on a particular index should be an effective hedging strategy against short-term stock market fluctuations.

The list of the most traded indices as of 8 January 2020

In the financial world, hedging is an effective risk management strategy.

However, to hedge with any success, you will need to elaborate and develop your own hedging strategy that will help you to minimize your exposure to the risk of uncertainty and significantly restrict your losses.

Using Options for Portfolio Hedging

Theory for building portfolios and hedging using Options. Includes simulations for applying the theory.

Disclaimer: Nothing herein is financial advice or even a recommendation to trade real money. Many platforms exist for simulated trading (paper trading) which can be used for building and developing the strategies discussed. Please use common sense and consult a professional before trading or investing your hard earned money.

In part 1 we discussed the basics of portfolio hedging. In this part 2 we’ll go briefly into options pricing theory and then apply the theory to understand how hedging works in practice. We’ll create various market simulations and see how a hedged portfolio would perform against broader market indices and common portfolios. If you’re already familiar with options feel free to skip past the “Options Primer” section and go straight into analysis and results.

You can find some of the programming of analysis and options theory here:

Poseyy/MarketAnalysis

Portfolio Theory, Options Theory, & Quant Finance. Contribute to Poseyy/MarketAnalysis development by creating an…

github.com

Options Primer

Let us frame the discussion with a quick note on risk vs rate of return. It is common to assume that this relationship is linear. There are many particular circumstances where it is not. Ultimately, our goal with hedging is to reduce risk without significantly impacting potential returns. Otherwise, there would not be any point to hedging. One would simply lower their exposure or increase their exposure to hedge, which would be linear risk vs return, not accounting for factors like fees, commission, taxes, insufficient liquidity, etc. We use this sort of hedge in practice, of course. As we allocate more funds we are increasing exposure and increasing risk. As we take funds out for cash or some other asset we are usually reducing risk.

The most ubiquitous vehicle with hedging is the put option. A put option is a contract which gives the owner of the option the right to sell an asset at a given price to the counterparty. A put option gains value as the price of the underlying asset decreases. Typically, a single contract will be for 100 shares. This single contract gives the right and not the obligation to sell those 100 shares at a specified price on a specified expiration date. European style options may be “exercised” only at expiration and American style options may be exercised at any time. We will quickly view the P&L diagrams for call and put options… Do note, however, that I have an article which goes more in-depth on these diagrams and some other options plays. It might be useful before continuing.

We can see the various diagrams for out of the money (OTM), at the money (ATM), and in the money (ITM) puts. As the underlying shares decrease in value we see the option contract increase in value.

Contrasting to puts, calls increase with value as the underlying shares increase with value.

We can price options with various pricing techniques. Of which, Black-Scholes is the most popular pricing method. There are various other models used such as binomial options pricing and Monte Carlo, popularized in options pricing for its use to price Asian style options.

where C is option price

S is the present value of the underlying asset

K is the option’s strike price

r is the risk-free interest rate (usually something like the 10-yr T-bill is appropriate here, currently 2.7%)

t is time to expiration

N being a normal distribution

σ being volatility

We can build out Black-Scholes in Python, excel, or whatever tool one uses for their analysis. Here is a sample model for pricing Apple a few months back.

Applied Theory

All of that’s great. But ultimately, we want to know how to use options for hedging in a practical sense for our portfolio. At its most basic, we can utilize puts to hedge long stock positions. Let’s say we have a basket of stocks we’ve modeled to be real winners. Let’s say this basket contains 30 stocks across various sectors and the portfolio has relatively limited beta. We might assume the positions are true winners but want to hedge away the possibility that a broader market downturn wipes out our positions. To do this, we might consider buying put options on the broader market (i.e. S&P 500 ETF Puts). And we can hedge our risk as we see fit.

If we assume our portfolio will almost always slightly outperform the broader market, putting on a hedge will limit risk while reducing returns by a less than proportional amount… How does this work out? Let’s test our theory by creating a hypothetical basket of 30 stocks and use SPY (popular S&P 500 ETF) Puts to hedge against broader market risk. We will assume we have $100,000 to allocate.

First, we can price SPY at different underlying prices using the same model as before. We will model a few different market environments. First, an environment where the broader market is flat after one month at 0%. Then we’ll model down 2.4% after one month, down 8% after one month, down 13%, down 24%, and up 6%:

We’ve modeled some various scenarios. We see that when the market is down we make significant profits on these puts and when the market is up we make very significant losses. However, these losses are capped whereas the gains are potentially massive. The most we can ever lose is the premium we pay per option. Of course, it is unlikely for SPY to drop much more than 23%, but we saw in years like 2000 and 2008 the S&P experience up to 50% drawdowns. With these puts we’re extremely protected against such scenarios; in fact, in most cases we’ll make massive profits. Let’s now view how our portfolio performs alongside our puts. We’ll assume the portfolio slightly outperforms the S&P 500 in all markets. By slightly outperform we mean if the S&P returns 10% we assume our portfolio returns 11 or 12%. And when the S&P is down -10% we will assume our basket of stocks is down 8 or 9%. We’ll assume we use $95,000 of our $100,000 for buying individual stocks. And we’ll use the full remaining $5,000 for buying SPY puts.

Here is how our returns play out in our various scenarios, using our models from above:

Each column represents a different market condition after one month. We see that in a flat market where S&P 500 is flat and staying at 297 (we assume our stocks returns 2%) the total portfolio is basically flat. If our portfolio performs the same as the broader market then our total returns would be down about -.57%. This is due to decay in our option price from passing time. In the next column, we see that if the market is down 2.4% our hedge pays off and we actually gain nearly 1%! Wow, we can immediately see the power of hedging. With the market down 8% we actually make a whopping 12%. With the market down 24% we make 82%. Of course, the market dropping 24% in a single month is highly unlikely. And we’re modeling on one month performance. If we buy OTM puts they’ll typically expire OTM and with a consistently flat market we’ll eventually see our puts expire OTM and need to reenter our hedge. Further, we’ll need to continually rebalance and allocate extra funds or spend time and fees for rebalancing. Hedging is not free, of course.

A downside of our hedge is that we’ll underperform the market if our stocks don’t outperform the index by a large enough amount. In our chart, in the year where the S&P 500 was up 24% our portfolio was only up 22.55%. Although one might argue that 1.45% you’re missing out on is worth being hedged against down markets.

Further Reading

I made a lot of assumptions throughout the course of the piece on prior knowledge of the reader. You can find more information in many different places, such as famous texts from the field. If you have any confusion on methods used throughout the course of this article feel free to drop me a comment or question below.

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