Hedging with options

Does not come free

This post aims to explain how we do hedging with options. But first, let’s start with a broader overview. To put it simply, hedging is the process of allocating a portion of your capital that is (supposedly) going to smooth a drawdown in your overall portfolio.

Ways to hedge. There are many ways one can hedge. A hedge could be adding plain short equity exposure of individual stocks in a long portfolio, which is in essence what long/short HF tend to do. Also, it could be implemented through a tactical trade by shorting, for example, ES mini futures, or by being positioned long an asset that would have a negative correlation to your portfolio (that used to work with US treasuries pre 2022). Last but not least, it could be done by buying options.

The classics. Let’s focus on the last part with some classic examples.

We are now nearing the end of the Q3 and given how much of a hot topic it is, it would not hurt to mention the elephant in the room. Most of you probably know of the JPM fund JHEQX, which is long equities but also aims to provide some protection to the downside. I won’t go deep but there is a lot written on the topic and if interested one should start with this easy explaination of @dampedspring. The protection (hedge) comes as a put spread - long the Sep 30 3580 puts and short the Sep 30 3020 put. They paid a premium for this trade, which was funded by shorting a 4005 call. Each end of quarter the structure is rolled. SPX closed at 3785 on Jun 30, so by buying a put at 3580, the fund’s drawdown is kept at c. 205 points or 5.4% for the quarter (unless at expiration SPX closes below the lower strike of 3020). The ‘catch’ here is that the profit would have also been capped at the 4005 level. It is a feature of ‘hedging’ that there is always a trade-off for protection, it does not come free.

JHEQX sizable position in the OI of SPX

Another classic example and much less sophisticated, is the simple strategy of having a 20 or 25 delta put always as a hedge in your long based portfolio. This will cost you dearly though, and in years such as 2022, when volatility remains suppressed despite a big pullback in the market, you will be left hugely disappointed.

Notice that not only in 2022 it gave suboptimal returns to the other portfolios, but it good years for the market the put tends to drag performance as well, as again protection does not come free.

How we do it. To begin with, let me remind you that we are short term swing traders, and we very rarely hold a position in our portfolio for more than 3 weeks to a month. Naturally, that leads us to only hedge tactically, when we believe the time and price action deserve hedging.

Yesterday for example, I noticed that some fixed income ETFs are behaving too well given what rates and the general market were doing. Look how MUB and PFF behaved compared to TLT and SPX.

PFF and MUB finished the day flat-to-positive and had decent intraday price action, despite the turbulence in equities and the disaster in the long term bonds. I suppose this is due to EOM inflows, which can be observed here:

X-axis are the calendar days in a month

X-axis are the calendar days in a month

One can see the historical performance in PFF and MUB during the last days of the month and although the pattern looks similar for TLT, the current environment/sentiment has totally superseded this effect (at least for now). I was wondering whether to get long the indices which are behaving well here, e.g. long PFF, but the abysmal moves in rates are too scary to even think of playing it long only. Hence, I looked for a hedge. A good choice would have been to short TLT, as what bothered me was the potential continuation of the increase in rates. However, shorting the underlying after those 2 days is also not a smart choice from a risk management perspective (do not want to short the hole), which led me to look at the options. With MOVE at the highs, simple calls and puts are expensive, therefore not a choice. I liked the 101 - 97 long Oct 7 put spread, which trades now for c. 1.3$. That way I would have more comfort going in the trade for the desired period while also having some protection if rates rise and TLT falls.

Another situation when we decided to hedge was before the recent FOMC meeting. We had decent short exposure. We were short REM through long put spreads and ratio spreads, short bitcoin, short perpetuals vs long PGX, etc. Given the uncertainty of the event and our long bias at the time, we took some of that exposure off and in addition looked for tickers we liked to get long. We got some exposure in TLT and ABNB. Again the current environment and our desire to be tight on risk management require us to know our risk at each moment in time, thus we structured those trades as synthetic calls - long the underlying and long near or ATM puts. The point of going long the underlying is to have a high delta from the start and get some flexibility to short calls later if we are right on the direction. Unfortunately, not only did the longs not perform well, but we had high opportunity costs having the exposure in the shorts decreased. Hedging does not come free.

Rarely are we caught much off guard but I would lie if I say it has not happened. Sometimes you are just unprepared for the exogenous events that move markets. When you feel the heat, there is not much time to think. In those cases, we simultaneously reduce exposure and also look for a momentum play as a hedge. The usual suspects are both calls on VIX futures or puts/put spreads/ratio put spreads on SPX and we tend to go for the latter. The feeling of getting green (due to the hedge) amongst the red ranks high in my emotional book.

Conclusion. We are swing traders and we are obsessed with risk management, so hedging is an ingrained part of our play book. We mostly play options and/or structure the trades as a pair so we are often ‘hedged’ on the specific trade idea. When we want to hedge on a portfolio level, we either look for relative strength/weakness in the products we follow or go straight to VIX/SPX options if caught off-guard.