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Over the Hedge: Volatility Hedge Update II

5 July 2019

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What a wonderful day to add to our hedge position. Yet another new high on the S&P yesterday while pushing hard to break 3000 lowers the cost to hedge.

Our introduction to the volatility hedge, Volatility Hedge, in April and updated in May noted that 3000 would be a tough resistance level to break. We hedged there and covered losses while exiting many positions as the market slid 215 points, just over 7%.

Our May hedge article, Volatility Hedge Optimization, proposed some different market types and how hedging might be applied to each.

In a June update, Volatility Hedge Update, the market was again pushing to break the 3000 level. With a nice "higher high; higher low" configuration, things were looking up. 3000 remained a challenge and it was a good time to replenish our depleted hedge position.

It feels like we are still in a Goldilocks market; as it ages, we will likely move to the Mama Bear market and trade sideways a bit. In Goldilocks, little or no hedging is required.

And yet, that is the time when hedges can be the least expensive.

This article will extend our hedging optimization conversation for this market type.

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Strategic View

Tariffs' influence has lessened with some recent rhetoric out of the White House. No progress, really, but some oil on the water.

The Fed has committed to a rate reduction which reduces the tension that has been overhanging that decision.

North Korea, China and the Middle East remain largely unchanged.

Oil was looking up with further commitments by the OPECkers to control supply. At the same time, stronger indications of demand slackening. Volatility likely the watch word for oil in the near term.

All told, things are marginally better at this time relative to a few weeks ago.

Establish the Hedge Parameters

The Initial Approach

With the changes in the Strategic Context, we think the Goldilocks market will continue. S&P 3000 will still be a strong resistance level to sustainably break through.

Without that sustainable breakthrough, riding sideways in the Mama Bear market will happen.

As such, looking for low cost hedging is merited.

In our June update we only added 1/3 of the hedge position required to cover our at-risk positions. As we were then and are now in a Goldilocks market, we buy into the hedge in 1/3 position increments.

We purchased 20 contracts, September VXX 40/46 vertical, for $680.

At this point, our requirements are:

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

  • Take action at the -10% level, approximately S&P 2700, to hedge a further 5% loss; based on our proprietary VXX/S&P relationship, built into our Trader Performance Coach© (TPC™) software, this puts VXX at somewhere around 40.
  • Total portfolio is $500k; ex-cash: $450k: 5% insurance is $22.5k; 1/3 is $7.5k

Our Volatility Hedging Tool©, built into TPC, guides calculating the appropriate VXX strikes.

An Alternate View

Technically, the VXX chart displays resistance levels at $32, $36 and $40.


We would like a low cost spread on the VXX that will provide protection on a significant pullback.

  • Setting up our spread above 50 will likely end in cost without value.
  • Given the move down, the $32 level looks attractive, depending on cost/value

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

Select the VXX Spread

We look for a return multiple of 8-12x; then the lowest break even price; and then lowest cost. This would mean that the hedge:

  • returns 8 to 12 times our investment back
  • kicks in at a smaller drop in the S&P than other choices
  • delivers that at a lower cost than other choices
Hedge Tool

We get a few good choices: 31/35; 32/36-38. Interesting that the 32/35 shows up with 12.5x, even better returns at a low cost. We will take that one.

Our Volatility Hedge Tool demonstrates that we could spend from $517 to $1,019 on these spreads. The leverage ranges from 7.5x to 12.9x across that range.

We get a 12.5 multiplier for $665 with the Sep 32/35; it breaks even at 32.18 or roughly 2750 SPX, down some 8%. This is nicely right on a VXX support level and somewhat below a SPX support level.


Not every market requires us to purchase insurance by hedging.

We know there will be times when hedging is the rational choice.

The best outcome is to lose the hedge cost completely as that means the small cost in insurance was outweighed substantially by increased value in the portfolio.

Resist the temptation to unwind a hedge as it loses money. Once purchased, 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%.

A hedging position reduces stress in continuing to commit capital to a rising market that is getting stretched, enabling continuing gains right up to the edge of the cliff.

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.

"Never agree to anything proposed on someone else's boat or you'll regret in in the morning." -- Michael Lewis, Liar's Poker