I'm looking for some resources on how to hedge a stock trading system against very rare adverse market events. I.e. I'm willing to suffer regular drawdowns in 99% of market conditions. However, in case of say an '87 crash, I want to limit my losses to X%. I know an investor holding a portfolio, would estimate beta and with an R-squared that is high enough, he would buy index put options with a strike set at the max. loss he's willing to suffer. But a typical trading system has (should have) low R-squared in normal market conditions, so using this approach seems inappropriate. Because these events are so rare, it also doesn't make sense to optimize the system using data from '87, as a next crash will likely happen under different circumstances. Another approach would be to hedge all individual trades with options, but this is expensive in terms of slippage and transaction cost and only possible if options are available. The safest way seems to be to take beta for each of the individual stocks the system traded, take the average of 5% highest betas and use this to determine the correct index put options to buy. This might be very expensive though because the betas supposedly will be high. Any thoughts on this?
taking current betas is useless because in a crash you portfolio's correlation will go to on. i think the best thing to do is look at OTM puts and focus on how much theta you are willing to burn
Liquidate the stocks. Don't bother "hedging". By definition, crashes occur at the end of a downtrend, not immediately after new highs are made........similar to October 1929, October 1987 and September 2001.
IMHO, the best way to 'hedge' is to build as much risk control as possible into your system. And this generally starts with simply staying as diversified as possible, and not placing all your chips on one color. In my experience there is no effective way to put on an overall hedge, that won't continually cut you with small losses while you wait patiently for the big event. Buy puts and you'll be paying for the insurance everyday. Not pleasant. Short the market and you'll be a very unhappy camper during rallies, which can surprise you at any time. Remember that in '87 and '91 (I was long in both markets), those who were patient and didn't panic were fine. We have an extremely resiliant economy and market, and if an event ever happens that puts the market flat on its back without a chance to recover, I think we have more to worry about than the S&P.