Equity Hedging - A Simple Overlay System

Discussion in 'Risk Management' started by OddTrader, Dec 31, 2011.

  1. http://www.elitetrader.com/vb/showthread.php?threadid=233645

    Equity hedging has been mentioned many many times on ET, wanting to find good solutions.

    I now would like to propose a simple equity overlay system for discussion.

    I want the equity overlay hedge system to be not only effective, but also low cost (or even better: producing alpha :) ).

    To be effective, the overlay system will use an options-based model. The most simple approach is to buy long puts and constantly keep a long put position all the time, 24 hours/7 days/ 12 months.

    To be low cost, the overlay system has to find a way of generating (good) income in order to offset (partly or fully) or exceed the expensive premiums of the long puts.

    I plan to prove a (unique?) method through buying additional put options during (projected) down trends of price movement.

    The system is purposely designed, therefor these additional put options will produce enough incomes to cover (beyond!) the expenses of premiums in the long run.

    We consider the system peforms well when both its average annual cost and maximum annaul drawdown could be kept to an acceptable benchmark level.

    There are some short-bias hedge funds or CTAs. But I don't know whether they use any similar approach as this proposed options-based equity hedging system.

    Your comments/inputs would be welcome!
  2. OSU experiments with equity overlay hedge
    The university foundation increased an equity overlay sixfold to test protection in down markets
    By Barry B. Burr
    Published: September 28, 2011



    A guiding principle of the Oklahoma State University Foundation could be: you can never worry too much about a bad thing.

    The foundation raised an equity hedging overlay allocation sixfold to $60 million from its initial $10 million move last year to test the strategy.

    The $500 million foundation isn't hoping for a poor investment market, but it is hedging to protect against a major market downturn, using indexed equity options.

    Jerry D. Clack, chairman of investment committee of the $500 million foundation, based in Stillwater, said the strategy — an overlay of indexed options on a diversified portfolio of U.S. and non-U.S. small-cap, midcap and large-cap equities — still is too new to demonstrate evidence of its value.

    For this year, through Aug. 31, with U.S. and international markets generally down for the eight months, the equities underlying the hedge overlay lost 2.33%, while the option overlay gained 1.73%, for an overall loss of 0.6% to the foundation, said Ryan Tidwell, director of investments.

    But from January 2010, when the foundation hired Gargoyle Investment Advisor LLC,Englewood, N.J., to manage the overlay, through the end of December 2010, the foundation underperformed on its hedged equity portfolio strategy compared to an unhedged equity portfolio. The underlying equities returned 18.64%, while the hedging overlay lost 4.8%, for an overall gain of 13%, Mr. Tidwell said.

    In 2010, when the foundation initiated the overlay, Mr. Clack said, “We didn't think there was going to be a big market move” upward. “The market moved up,” while the foundation hedged for a decline.

    “But we captured a lot of the upside,” Mr. Clack said. “We (were) not that upset when we made (13%) instead of the 18.6%” on the hedged equity portfolio strategy.

    The foundation's goal is “to capture 70% of the upside (of the equities) and protect ourselves (by limiting losses to) 50% of the downside,” Mr. Clack said.

    In the long term of three to five years, “if we can (do that) we would outperform” unhedged equities, Mr. Clack said. “We haven't proven yet we can protect ourselves.”

    Still, he said, “We've been pleased with what they (Gargoyle) have done.”

    The strategy has given the investment committee experience to prepare potentially the entire fund to withstand a “black swan,” or significant fall of more than 25%, Mr. Clack said.

    “We've talked about it,” Mr. Clark said referring to committee discussions about extending hedging strategies. “But we have no plans to go further at this time. We've talked about developing black swan strategies for big declines.”

    “But we've now gotten comfortable with Gargoyle and what we are trying to accomplish. If we see (major) volatility will be here for a long time, we might look at (more hedging) strategies.”

    “At some point in time, if we get very concerned about the equity markets, we might use it. Your other alternative is just selling all your stock,” Mr. Clack said.

    “We are really not using enough option hedge for it to be significant” on the overall foundation fund, Mr. Clack acknowledged.

    “The biggest part of (initiating the strategy) was to get the account set up, get the education process up to where if we decided” to protect more of the fund for a black swan event the foundation's investment committee would have knowledge and comfort with hedging strategies.

    Mr. Clack, who is also senior vice president-investments and wealth management adviser of the Tulsa-based Clack/Jelley Group of Merrill Lynch, said the foundation initiated the hedging strategy because it wanted to maintain significant equity exposure yet protect against major short-term market downturns or long-term underperformance.

    “A lot of people got caught flat-footed in 2008” in the financial market crisis, Mr. Clack said. “We don't want that to happen to us” now.

    Instead of reducing the foundation’s equity allocation, Gargoyle decreases its equity exposure by selling U.S.-listed major-market index call options and dynamically managing the options portfolio so that the foundation is hedged at all times, Mr. Clack said.

    Collecting options premium every month makes this strategy cost effective, Mr. Clack said. “Over the short term, you are giving up some of your upside to buy downside protection.”

    “It gets expensive it there is no volatility in the market because the calls and puts end up expiring worthless. So if you are going to use the strategy, you have to be willing to lose money.” Mr. Clack said.

    “Now we still have to wait and see how this dynamic option hedge performs when the market goes down (say) 18%,” Mr. Clack said. “Do we only go down 9%? That's the key. We have not been through” that kind of down market.

    Gargoyle uses U.S. and non-U.S. options, trying to correlate the hedge closely with the underlying equities.

    “It's not a perfect hedge,” because the options don't match the portfolio exactly, Mr. Clack said.

    Gargoyle adjusts the hedge daily as needed to make sure the overlay's mix stays aligned with the underlying portfolio and with other guidelines.

    “There's a cost to all insurance,” said Joshua B. Parker, president of Gargoyle.

    “The cost for our strategy is we are going to be a drag on performance when the market is up, (but) we're going to be protecting performance when the market is down,” Mr. Parker said.

    “In a down year, we cover about half the loss (and) in an up year, we are about a 20% drag,” he said. “That's huge asymmetry. By keeping volatility down, by protecting the downside,” the portfolio should outperform over the long term, Mr. Parker said.

    “We say to our clients you want to be hedged every minute of every day of every month of every year,” Mr. Parker said. “The market will do what it will do. We can't predict when tsunamis will hit, when there will be revolutions in the Middle East and subprime problems in the U.S. — and good things happen (also). Just stay hedged.”

  3. rmorse

    rmorse Sponsor

    Because I have a tendency to hate buying premium, I would hedge a long portfolio with selling SPX OTM long dated calls. In theory, you've chosen these stocks because you feel they will outperform the market. So, I would not want to pay for insurance ALL the time. I believe the cost is too high over time. And, in general, OTM Puts are skewed higher than other options, so the price you're paying can be very expensive.

    By selling OTM long dated SPX calls vs a long portfolio, you have hedged some market risk, increased your return over not hedging, and have the tax advantage from the long term gains on the stocks and the tax advantage from income on options with cash indexes. Also I like this over selling calls on the individual stocks. If a stock you chose to outperform does, your not taken out of the stock.

    Just my opinion.

  4. Two sources below:



    Hedging with Options

    2. Selling Calls for Income
    However, the sale of calls provides no substantial protection against a large break in the market, unlike the put purchase.
    --- Caplan (The Options Advantage, page 142)

  5. bob, while everything you said is 100% accurate, as the poster below mentioned it doesn't protect against a large break in the mkt. this is a topic i have spent a lot of time thinking about and i've come to the same conclusion many of you already have: there is no cheap way to hedge from a large mkt decline.

    using a covered call strategy usually only brings in around 5% extra yield every year. if there's a large mkt decline and you're using leverage which most of us are then that 5% won't help that much.

    taking that strategy one step further i've heard of traders putting on a collar by taking the premiums from selling 5% otm calls on the spx (e.g. spot at 1000, sell 1050 calls) and buying 10% otm puts. as you mentioned the iv is almost always higher for puts than calls b/c everyone wants to hedge so the extra premium you get from selling a closer strike for the calls can pay for the farther away strike for the puts.

    i could go on for hours w/ diff scenarios but bottom line hedging costs money, there is no way around it (if you've found one i've loved to hear it) and it is absolutely necessary if you want to be around long term b/c there WILL be another black swan, but we just don't know when.
  6. rmorse

    rmorse Sponsor

  8. rmorse

    rmorse Sponsor

    OddTrader: Please send me an e-mail with information about C2. I tried to PM and E-mail message you, but you're turned off. If never heard of the service.

  9. gkishot


    #10     Jan 1, 2012