WEALTHWYSE

Ok, so now that we are back, lets get back to the previous dsicussion of hedging. In the previous post we discused several ways to hedge portfolios, now lets discuss the second question - when should one hedge a long portfolio? Options are: 

1) Always 

2) never 

3) Opportunistically, based on some trigger

Never is not a good idea (see the operation analogy in previous post). Always is a viable option, specially if you are running market neutral or long short sort of strategies, your portfolio automatically provides some hedge and as you feel more quezy about market getting overvalued, you can increase the short side of the book. However, in any case, hedging costs money (real money if you are buying puts, oor opportunity cost if you are not buying stocks/call) . Can we optimize, so we hedge only in certain scenarios? Possibly. For example, consider this approach -  every time the index (say NIFTY) moves up 1 standard deviation from its long term mean on a selected valuation indicator (say price to book ratio), reduce exposure by 50%. So, once the market reaches 2 standard deviations from the long term value, the net long exposure become zero. True mavericks, at that point, can still continue and go short 50% if the market reaches 3 standard deviations from its mean, and so on.  

While simple, at least this gives you some plan. Of course, there are questions - how frequently you check for this value & re balance? Also, what if you get up one morning and market is down 10%? What if after you trimmed your exposure, the market corrects and comes back to your buying zone (within 1 standard deviation of its long term mean)? You can probably go back and buy the same stocks again which you loved, or even better, find better bargains. There is also one serious problem in this simplistic framework – Markets can remain expensive for a long time. Typically, the last phase of a bull market is when the highest gains are made (agreed it’s the most risky too). Dotcom was a bubble in 1997 & housing was a bubble in 2005, and in both cases it took full two years before the crashes arrived. Exiting marketing in ’97 or ’05 was probably not a great idea. So, clearly, you don’t want to cut your exposure too early.

The approach which I prefer is targeting portfolio volatility. If you know the overall weighted volatility of the portfolio, you can target a certain level for for this. In crashes, the overall volatility (downward volatility, if you want to be truly savvy) spikes. In this framework, we hedge as the portfolio volatility goes above a certain threshold. Extent of hedge is increased as the volatility moves higher.

This can be a simple strategy to execute (and systematically monitor). You can check daily for example, if portfolio volatility is higher than the threshold, reduce exposure (using any of the above strategies), if not, do nothing. This way, you can sit calm during the entire up move, when typically the volatility remains low and reduce exposure only when the dreaded turn arrives. One can make it even simpler by tracking the index volatility and act when that moves above a certain threshold. Do keep in mind am simplifying things for the sake of discussion, and in reality, one must combine volatility with valuations and the net effect must act as the trigger. 

Just one thing to keep in mind, in this strategy, you need to be quick, cause when the crash arrives, it’s gonna be quick. Lastly, don’t try these unless you really understand what you are getting into. On average, without full understanding of derivatives, it’s much simpler to sell the stocks, reduce exposure and wait till sanity returns.