Sure. There are many times that you can say that volatility is cheap. We use the VIX and CBOE Skew as examples. VIX/absolute volatility is cheap on an absolute/historical basis or hindsight - ie VIX at 11 relative volatility across the SPX strike prices are cheap from a skew/smile perspective - when CBOE skew index is at 120 VIX/current volatility is cheap based on the forward curve of various maturities/expirations - ie forward curve is in deep contango rather mild contango or even backwardization You would be tracking volatility levels and deciding when to put on some insurance based on relative undervaluation rather than making the guess of where the market is going. Volatility after all is mean reverting. Hopefully, this lessens the performance drag on your portfolio. In the best case, you improve your risk/return ratio and justify employing more leverage.
a little wordy, but he asked me to elaborate we are just scratching the surface not even going into the mechanics of the trade. personally i just dial down equities exposure by getting some bonds/fixed income but he asked on an options forum
Sounds like a few things being confounded here. What do you want? What problem are you trying to fix? If I understand correctly you've got something like a 130:30 portfolio, which will be making its money from relative value, a long bias to equities and a variable beta to equities. a) If I have a strategy that is mostly long, but I don't want any equity exposure on average (maybe you've too much equity exposure elsewhere), then I should sell a constant hedge equal to my average exposure. b) If I don't think the overall long/short timing of the portfolio is a profitable signal (you can check this) then I should sell a hedge which varies according to that exposure, or tweak the strategy so its always equity neutral. c) I could add a separate signal to time the overall long/short of the index, to replace the natural timing of the underlying strategy. For example I could use a trend following signal on the index. Now how do we hedge in a and b? We can do a linear hedge (sell a future), or a non linear hedge: an options hedge or a synthetic options hedge. A short only trend following signal will give you a synthetic long put (a symmetric signal is a synthetic long straddle). If implied volatility is low then it makes more sense to buy options. If implied volatility is high then it might make more sense to do the hedge with the synthetic option. Note that the trend following signal can be both an additional strategy, and a way of hedging.
I hedge all the time in Forex, but its quite simple, what you guys are talking about seems a bit over complicated
It's possible that hedging the long side to market neutral would free up additional capital, which you could use to scale up the whole trade. In that sense, hedging may not just tie up extra capital in exchange for risk reduction, but also provide some alpha in that it lets you do more of the alpha components.
I don't get it? I just take trades in the opposite direction on the same underlying, this is a hedge, is it not??
Either the hedge reduces enough risk that you can trade larger to make up for reduction in profits during up years or it doesn't. have you looked at buying long dated SP500 puts? constant cost with more protection when you need it and you benefit from increases in volatility.