HPI10alpha Program (TaP©)

Over the Hedge: Volatility Hedge Update

23 June 2019

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Introduction

As the markets hit another new high, it is time to consider putting on more protection. Referring to Volatility Hedge Optimization, we had a fairly nice Goldilocks market from S&P 2740-2950. Breaking 3000 will be a challenge; we may see some chopping around in a Mama Bear market as it consolidates. Protecting to the downside is unlikely to be much cheaper than it is right now.

Should the market fail a couple times at a strong breakthrough toward 3100 we will have our Papa Bear market.

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Strategic View

The big three risks haven't changed much. Tariffs linger, the Fed waffles, North Korea, China and the Middle East play mind games.

Of these, tariffs seem to have the most emphasis right now. Positive real progress, not the Trump fake paper wave, will have a significant positive impact while continuing rhetoric will leave us consolidating here with a downward bias.

Funniest talking head comment, "Banks may be so bad they are good". This in the face of nearly universal agreement the Fed will be cutting rates. Nonsense.

The markets gained 2-3% last week and the S&P set a new record high by peaking 5 points above the previous high. Thursday left us optimistic of a strong Friday that did not materialize. Fridays can be like that. This one ended 14 points down from the new high leaving a long upper shadow on the candlestick. Ominous? Maybe. Monday will provide some important indication of direction.

Establish the Hedge Parameters

The Initial Approach

We think we are entering a Mama Bear market. We cannot know how long that may last and will not know we called it appropriately until we get another 4-5 days of trading data.

However, this is the ideal moment to add to our portfolio hedge on that thesis as the cost will be relatively low. We currently have an August VXX volatility hedge on. Adding would be best by buying a September hedge.

We are hedging the market so will use the S&P 500 and VXX. We continue to be willing to take a 10% loss so want our hedge to kick in after that, approximately 2670 on the S&P.

Based on our proprietary VXX/S&P relationship, built into our toolset, Trader Performance Coach© (TPC™) software, this puts VXX at somewhere around 40.

At this point, our requirements are:

Allow a 10% market correction; this is our risk tolerance;

  • Take action at the -10% level to hedge a further 5% loss;
  • Total portfolio invested is $500k; ex-cash: $455k

Our Volatility Hedging Tool©, built into TPC, will guide you in calculating the appropriate VXX strikes.

An Alternate View

Looking at the VXX from a technical perspective, we can note some levels of resistance and support that will help inform our decision on the appropriate hedge.

VXX History

Choosing a low cost spread that may reasonably land in the money on a significant pull back is the goal. Much like our last look:

  • Setting up our spread above 50 will likely end in cost without value.
  • Setting our spread below 32 will likely end with high cost and a small payout.
  • Something that hits maximum value above 40 looks to be a nicely balanced position.

Combining this with the output from the Volatility Hedge Tool we can be more confident in our choice of strikes.

Select the VXX Spread

Our Volatility Hedge Tool demonstrates that we could spend from $2,040 to $2,469 on these spreads. The leverage ranges from 11x to 13x across that range.

As noted in the prior article on hedging, there is no approved solution provided in the back of the book. We want something above 10x leverage at a reasonable cost. That lands us at the Sep 40/46 spread for nearly 13x leverage at a total expected cost of $2,040 assuming the strike prices do not change much.

For a recent volatility hedge back-testing validation example see Volatility Hedge Optimization.

Learnings

There is no requirement to hedge. At all.

It is unwise to never hedge knowing full well that there is a reasonable chance of losing your hedge cost completely.

Unwinding a hedge rarely has merit. Once bought, leave it until expiration to cover the entire time period with insurance.

Never ever convert a hedge to a trade. This hedge may well go to 30-50% profit before expiration. We want to close it when it is up 1300% and our portfolio is down 10%.

We may use VXX to take new and different positions to take advantage of a non-catastrophic falling market. Those are legitimate trades for profit while this position is protecting your capital.This position eases stress in continuing to commit capital to a rising market that is getting stretched, enabling continuing gains right up to the apocalypse.

Buy insurance only for the invested portion of the portfolio. Generally, cash is its own insurance against loss.

As noted in the previous article:

  • Choose level of risk that you are willing to accept; whether that is 5%, 10% or more, it is not wrong as it is your loss tolerance level;
  • Select the amount of insurance to buy above your base; this is really a measure of how fast you can act to close positions and move to cash;
  • Given the base level of risk, establish your 'point of no return', that level in the current market where you will pull the trigger on the hedge process irrespective of any other influences: no whining, wishing, hoping ...;
  • If the market tanks and hits your target level, close your positions as quickly as you can; when complete, immediately close the hedge. The hedge is not a trade.


"Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway." -- Warren Buffett