Chat with us, powered by LiveChat
The Better Way to Invest

< Back to Main Index

Benefits of Hedging a portfolio

December 5, 2008
Be the first to like.

Last week I discussed SPA3 risk profiles and the differing effects that each have on overall portfolio performance. This week I’d like to discuss the benefits of using a hedging strategy to offset potential losses from a long only, medium term equity trading strategy such as SPA3.

When I set about designing and developing the SPA3 system which was first released to our customers in August 1998, my #1 criterion was to develop a strategy that would provide the user with an EDGE under all market conditions. This has not changed and although SPA3 has been improved over time the principles and signals of the strategy remain the same bar the addition of one signal in 2004.

From 1998 until November 2008, SPA3 has only been an investment strategy for buying stocks. It has contained no short selling strategy. With a 53% retracement in the market index and drawdown in the SPA3 public portfolio hitting as high as 32.51% it has justified the devising of a low correlated shorting strategy that would be executed during SPA3 high market risk periods. Furthermore, to trade through such a phase in the market and not make a change to a trading methodology that can improve its execution and performance in the future, would be irresponsible and naïve for a systems research company. My aim was to introduce a hedging strategy where SPA3 users would short sell an ASX200 CFD when a SPA3 high market risk signal occurs. The hedge would be put in place to reduce drawdown in a falling market.

It must be said that eliminating drawdown so that the portfolio makes money under all market conditions is extremely challenging. My aim was to have portfolios tread water in a falling market and then maximise the returns that can be made through medium term trading equities when the market starts to move in an upward trend again.

I have placed the two equity curves of the two strategies below. Figure 1 shows the unhedged long only SPA3 public portfolio from January 2001 to present. It has traded through September 11 2001, the 2002-2003 bear market where a 20% retracement occured in the index, and the recent bear market.

FIGURE 1. SPA3 Long only – no hedging strategy

When looking at the performance of any portfolio it is important that you firstly have a large sample of trades in differing market conditions. This portfolio has just that. The blue line is a marked-to-market equity curve of the portfolio and the black line is the All Ords index. You will notice that the out-performance over 7 years and 10 months is $226,980 starting with a $100,000 portfolio.

Typically, SPA3 portfolio’s have achieved half to two thirds of the drawdown of that of the All Ords in a falling market and have achieved around double the rise in a rising market, depending on portfolio size. You will also notice the portfolio’s equity curve is similar in shape to the All Ords as this portfolio trades stocks long only.

I know that a 53% retractment in the index affects SPA3 portfolios negatively even though they have out-performed the index. However, performance could be improved by further reducing drawdown.

Figure 2 shows the results of the SPA3 public portfolio including the SPA3 hEdge strategy. It has been run over the same period with the exact same long positions in place. The only difference is that the SPA3 hEdge trades have been added to the portfolio. Comparing the two equity curves in Figure 2 you will now notice that when the market falls and rises sharply the hedging strategy kicks into play causing the portfolio equity curve to inversely mirror the All Ords index.

FIGURE 2. SPA3 with hedging strategy

There maybe times in a bull market when the hedging strategy will give money back to the market because of small ‘false’ high risk markets happening along the way. This is a lot more manageable, as investors struggle considerably more with drawdown than not making as much on the way up.

From the SPA3 equity curve performance in Figure 2 it is clear that the results of employing the hedging strategy far outweigh not using it. By simply short selling index CFDs when a high market risk signal occurs, we have actually been able to eliminate drawdown during this bear market whilst at the same time remaining committed to our long only equity portfolio although at greatly reduced exposure.

Figure 3 lists the hedge trades over the life of the portfolio. Please make note that in 7 years and 10 months the portfolio has been hedged a total of 36 times. There have been 22 loss trades totaling $84,057 and 14 winning trades totaling $240,528, this makes the winning trades 2.861 larger than the losing trades. This is an edge. The hedge position sizing is calculated mechanically using the SPA3 portfolio manager.

FIGURE 3. SPA3 HEDGE TRADES

What the charts are unable to show are the psychological benefits of employing a hedging strategy. The charts can’t show the sleepless nights and periods of intense worry and stress experienced by those traders hanging onto “quality” stocks during these rough times and watching their portfolios lose value day after day as the market fell sharply from its dizzy heights.

For long term investors with a long only view of the market, and for those unable or unwilling to use short selling of equities or derivatives in their trading, the use of a hedging strategy adds security to your portfolio. It ensures that portfolios can be maintained, dividends still received, and long trades still entered, even though the market is falling, as the value of the portfolio can be offset by hedging. You will still need market generated trigger or signal as to when to and when not to hedge. This is imperative as in a rising market you will give it back plus more if the hedge is left in place. In a fast falling market, such as the one we have recently experienced, it can also actually result in hedging profits being generated – a nice bonus!

Like our blog? Share the love!
  •  
  •  
  •  
  •  
  •  
  •  
Be the first to like.

Comments

  • kelvin wade says:

    Has Garry designed it , so that we dont have to do all this charting . Is there a service where clients are on a hot list [ via sms] and cleints can be advised that a buy/ sell singal has been reached on a stock. We are then advised of this stock in real time and can choose whether to buy or sell the recomended stock.

  • Trevor says:

    A hedging strategy is essential but short selling CFDs is not likely to be acceptable to the regulators for a self managed fund (SMF), which may have to resort to other strategies such as a taking a long position on an index put option. Are you looking at being able to provide such assistance for your SMF clients of which I would be one?

  • Fastbucks says:

    Comment to Trevor. You can run a CFD acct in an SMSF.During the recent shorting bans, it was legal to sell ASX CFDs so a hedge would have been maintained. So, the answer would appear to be that you can implement a hedging strategy in your SMSF.

  • Benny says:

    Is it reasonable to think that the high market/sector notifications that suggest hedging have a similar edge to the share buying & selling notifications so if you use risk strategy No 1 you could hope to profit in the current market?

  • Victor says:

    From the table “SPA3 HEDGE TRADES” above, there appear to be 3 periods where the daily SIROC cycles above after cycle 4 were hedged, whereas in the HEGDE manual (p.23) the recommendation is for no hedging of these cycles. Am I missing something?

  • Trevor Cocks says:

    The strategy sounds interesting and looks good when comparing the two charts. Will Sharefinder supply the hedge buy/sell signals and necessary training as part of SPA3 or will it be at an extra cost? Also what’s the best way to select a broker for short selling CFD’s?
    Thanks Trevor

  • Dean says:

    What about increasing your “edge” further by going long on ASX200 cfd when market is LR and using the daily buy/sell signals?(reversing the hedge)

  • Gerard says:

    Its good to see development in this direction.
    What exactly do the letters “DS” in the DS Hedge signal stand for? (Damage Stopper?)

    When can we expect development to the point where SPA3 will have these signals built in?

    Thanks Gerard

  • Rodney says:

    Would this hedging strategy work as effectively with the purchase of put options? when an SPA hedging signal is generated.

  • Gary Stone says:

    In reply to Trevor:

    “A hedging strategy is essential but short selling CFDs is not likely to be acceptable to the regulators for a self managed fund (SMF), which may have to resort to other strategies such as a taking a long position on an index put option. Are you looking at being able to provide such assistance for your SMF clients of which I would be one?”

    As Fastbucks stated, you can use CFD’s in your Super Fund.

    If you are uncomfortable with using CFD’s in your SMSF then you can use the SPI (futures contract on the ASX200) or, as you say, buying a put option on the XJO. ETO’s are more complex to learn than CFDs for those that have never used either.

    If using a Put option is preferred then ensure that you buy an in or at the money Put that has at least 2 months to run to expiry. Leverage is not linear with ETO’s so the hedge cover that you get will vary and probably not be the same as CFDs or the SPI.

    Regards
    Gary

  • Gary Stone says:

    In reply to Benny:

    “Is it reasonable to think that the high market/sector notifications that suggest hedging have a similar edge to the share buying & selling notifications so if you use risk strategy No 1 you could hope to profit in the current market?”

    The operative word is “current market”. SPA3 hEdge is designed to come into it’s own during decent bear markets so using Risk Profile 1 (which means being 100% cash for all 56 weeks bar 8 since 16 November 2007) would indeed have been nicely profitable over the last 56 weeks.

    However, over the 4.5 years from March 2003 to November 2007 Risk Profile 1 combined with SPA3 hEdge would not have made anywhere near as much profit as Risk Profile 2, 3, 4 and 5 combined with SPA3 hEdge. We have to be look at both sides of the equation and be objective about we individually use a hedging risk management strategy.

    Regards
    Gary

  • Gary Stone says:

    In reply to Gerard:

    “What exactly do the letters “DS” in the DS Hedge signal stand for? (Damage Stopper?) When can we expect development to the point where SPA3 will have these signals built in?”

    Damage Stopper is a good suggestion but DS stands for “Daily Sell” as the hedge uses the SPA3 Daily Sell ‘trigger’ signals. This is important as base SPA3 concepts have been used making SPA3 hEdge consistent with SPA3 as a whole.

    Showing “built in” SPA3 hEdge signals on the charts will not be implemented until late Q2 / early Q3 2009.

    Regards
    Gary

  • Gary Stone says:

    In reply to Dean:

    “What about increasing your “edge” further by going long on ASX200 cfd when market is LR and using the daily buy/sell signals?(reversing the hedge).”

    Good question. This is possible however we have not conducted detailed research on this….yet. We know that SPA3 Low Risk periods have an edge that is why SPA3 portfolios maximise exposure during the SPA3 Low Risk market periods. Therefore trading the SIROC daily cycle will have an edge.

    The beauty of using CFDs to do this is that such a strategy can be traded alongside an equities portfolio using the equities as collateral therefore not requiring additional cash to trade the strategy. (Certain equities can also be used as collateral to cover margin for the SPI.) Money management rules can determine the level of leverage.

    However, we are getting a little ahead of ourselves. Stand by for a more rounded-out product in 2009 that goes beyond trading just the ASX200 (long and short) and looks at tradiing ETF’s (and even CFDs of ETF’s) around the world.

    Regards
    Gary

  • Gary Stone says:

    In reply to Rodney:

    “Would this hedging strategy work as effectively with the purchase of put options? when an SPA hedging signal is generated.”

    See my reply to Trevor above. The problem with using Put options is that leverage is not linear with ETOs and their effectiveness will depend on time to expiry and the level of implied volatility at any given time.

    Also the availability and spread of at or in the money Puts on the XJO will also be a problem. My view is that investors will become frustrated with the RT’s that make a market for such specific Puts.

    Happy to hear anybody’s recent experiences with buying XJO puts or even equity Puts in or at the money since January this year.

    Regards
    Gary

  • Ralph says:

    Hi Gary,
    I think the intersting bit will be once you automate the hedge function we will be able to run it through the backtester and get the true results ie compounding without drawdown that will be very interesting and I think profitable

  • Sean Baker says:

    In reply to Kelvin;

    Gary has designed the SPA3 hedge but at this stage it is manually implemented.
    We haven’t gone down the sms or real time alerts track because that’s the beauty of SPA3, 10 to 15 minutes a day once the data is available at 7.30 pm.
    Hopefully, SPA3 customers get somewhat of their lives back, rather than looking at the market all day long.

  • Gary Stone says:

    In reply to Trevor Cocks:

    “Will Sharefinder supply the hedge buy/sell signals and necessary training as part of SPA3 or will it be at an extra cost? Also what’s the best way to select a broker for short selling CFD’s?”

    There is no additional cost for SPA3 hEdge. It is a risk management strategy that is part & parcle of SPA3 and SPA3CFD. The necessary documentation is provided which discusses the various instruments that can be used to hedge.

    Also, we run regular Wednesday afternoon webinar training sessions which also covers SPA3 hEdge from time to time.

    There is a choice of brokers which has been discussed in detail on the Forum on this link http://forum.sharefinder.com.au/index.php/topic,1165.msg4204.html#msg4204 .

    Regards,
    Gary

  • Gary Stone says:

    In reply to Victor:

    “From the table “SPA3 HEDGE TRADES” above, there appear to be 3 periods where the daily SIROC cycles above after cycle 4 were hedged, whereas in the HEGDE manual (p.23) the recommendation is for no hedging of these cycles. Am I missing something?”

    Well observed and thanks for pointing this out. There were indeed 2 periods where daily SIROC cycles > 4 were incorrectly hedged.

    The 3rd period that you noticed was finger trouble where “DS Hedge” was selected in TradeMaster instead of “High Market Risk”. This was the hedge on 19/11/2007 which makes the 2 hedge trades on 18/12/2007 and 4/3/2008 cycle 2 and cycle 3 hedge trades, not cycle 4 and 5 as they appear above.

    The other 2 periods are in 2002 and 2006. In 2002 the cycle 5, 6 & 7 hedge trades on 5/9/2002, 20/9/2002 & 12/11/2002 have been removed. In 2006 the cycle 5 & 6 trades on 16/8/2006 and 12/9/2006 have been removed. As would be expected SIROC cycles > 4 generated net loss hedge trades so the portfolio is $17,816.87 better off without these trades.

    The corrected Figure 3 (with Cycle Factors) can be viewed at this link: http://gary-stone.com/files/closed_hedge_trades.jpg

    Regards
    Gary

Leave a Reply

Your email address will not be published. Required fields are marked *