Black Swan Events are defined as surprises that have a major impact and are typically rationalized by hindsight, as if it could have been expected. In finance, examples of Black Swan events include the stock market crash of 1987, as well as Standard & Poor’s Corp.’s downgrade of the US Government Credit Rating this past Friday, August 5, 2011.
The downgrade was an unprecedented event and the S&P 500 lost 6.66% the following Monday. Whether the downward trajectory of the past two weeks continues as it did in 2008 or bounces back is out the hands of the individual investor. How that same investor manages the risks inherent in trading the stock market, however, is very much in their control.
The first point here is that Black Swan Events cannot be predicted. The second point is that these events have a major impact often negative. So how does one protect their portfolio against unknown negative future events, while still being able to take advantage of positive ones?
Building robustness into a trading portfolio is a first step not just toward managing against these potential outliers. It is also a first step toward managing against overnight and market risk, as well.
In early April 2011, two new risk management features were added to The Machine. The first new feature, the Returns Distribution Histogram, allows traders to see what the simulated historical returns look like for any portfolio over various periods of time from 1 day through 10 days, 15 days, 1 month, 2 month, 3 month, 6 month, and one year. Traders can also plot current estimated return percentage for that time period to determine whether the returns are within +/-1, 2, or 3 standard deviations or to highlight an event that is outside of all historical data. For example, a Black Swan event is usually defined as a four standard deviation move and a risk that has less than 1% probability of occurring. You can read more about this feature in Rob Davenport’s article “Getting Knocked Down and Coming Back” in this month’s newsletter.
Dynamic Hedging Explained
The second new feature, Dynamic Hedging, is a risk management technique that can be used to reduce the inherent risk associated with holding stock and ETF positions overnight. It is a tool for reducing volatility, smoothing returns and isolating alpha.
Dynamic hedging seeks to minimize the market risk that portfolios are exposed to when the markets are closed. Dynamic Hedging essentially means going home each night with equal dollars (capital) allocated on the long and short sides so your portfolio is dollar and market neutral. The Machine contains a number of unique dynamic hedging schedules in order to create a market neutral portfolio and traders must decide which, if any, to utilize.
The first step is to decide the type of Schedule to maintain for the hedge. Users may hedge on a Close to Close, Close to Open or a Weekends & Holidays – Close to Open schedule. Each of the three schedules requires calculating the hedge at different intervals and involves differing amounts of transactional costs. In the near future, an additional Open-to-Open schedule will also be available in The Machine.
The second step is to decide which Index to utilize: S&P (SPY/SH), Dow (DIA/DOG), Nasdaq (QQQ, PSQ) and Russell (IWM/RWM).
The third step is to decide whether to institute a 50% hedge or a 100% hedge.
Once traders have made these decisions, the final step is to calculate the initial Long versus Short exposure in your portfolio and rebalance according to the selected schedule.
The sample portfolio discussed here will assume $100,000 in capital, the Close to Close schedule, the S&P index and a 100% hedge. For this example we will use the actual closing price of the simulated trades. However, in actual trading when using the Close-to-Close schedule, the hedge should be calculated and rebalanced prior to the close, and the shares should be bought or sold at or near the close of the market each day.
Dynamic Hedging looks at the daily net exposure (long exposure minus short exposure). For our example we will assume that the initial exposure on Day 1 is 80%. In other words, $80,000 of our $100,000 total capital is in an open long or short position.
Then we will assume that the exposure for the portfolio further breaks down to 60% long exposure ($60,000) and 20% short exposure ($20,000). Thus, our net exposure is 40% or $40,000 net long:
- 60% – 20% = 40%, or
- $60,000 – $20,000 = $40,000
A 100% hedge would therefore require an additional $40,000 in capital to purchase shares of either Short SPY or Long SH. A 50% hedge would require you to purchase $20,000 of SH or to short $20,000 of the SPY.
Once the initial hedge is in place, daily rebalancing would be required of the amount of shares in the position (i.e. shares need to be bought or sold in order to adjust the position to the new daily net exposure).
This ensures your portfolio is always market neutral on a dollar basis. This helps to protect your portfolio against the downside risk associated with a net long position or the upside risk associated with a net short position.
In order to utilize Dynamic Hedging appropriately, traders must have sufficient capital available to purchase the shares. If a trader were to allocate $100,000 to a portfolio and place a 100% hedge, the trader would need to have an additional $100,000 in capital available; a 50% hedge would require an additional $50,000 in capital in the event that the net exposure was 100%.
Sample Portfolio: Pro IRA Portfolio
Let’s take a look at the Pro IRA Portfolio statistics in The Machine, from January 2006 forward, to determine how Dynamic Hedging affects the returns. While in many cases Dynamic Hedging lowered positive simulated returns, as in May 2011, it has also limited negative returns as is the case in June 2011. Dynamic Hedging has also typically reduced the maximum drawdown of a portfolio and lessened the number of days of the drawdown.
The Machine development team was also able to produce a rough estimate of how Dynamic Hedging would affect the returns for July 2011 and the most recent 30 day period in The Machine for the Pro IRA Portfolio. They were able to provide the data with and without a 100% Hedge shorting the SPY on a Close-to-Close schedule.
From August 1 to August 10, 2011 the S&P 500 Index lost 172 points or approximately 13% of its value, including the unprecedented events occurring from August 5th to 8th. During this same time a Pro IRA Long only Portfolio with a 100% hedge lost 6% of its value.
One Day Return Chart of Pro IRA Portfolio v. Pro IRA with 100% Hedge
Despite the slight cost to performance, in terms of additional commissions and reduced returns, many hedge funds and professional money managers use hedging, or insurance of some kind, to avoid being blindsided by the markets. We offer this feature is offered with every license to The Machine. Dynamic Hedging can help to protect portfolios from unexpected events since no one can control when the next Black Swan will occur.
Alternatives Implementation Methods for Dynamic Hedging
Back in May, Darrell Kay of Kay Investments discussed using the Dynamic Hedging feature for IRA portfolios that are unable to short. In that article, Darrell indicated some additional ways to implement hedging in a portfolio including Options and mini futures.
Specifically, Darrell highlighted in-the-money put options on index ETFs and the S&P 500 e-mini contract. The advantages of the mini index futures contract include the fact that the “commission overhead is next to nothing”, utilizing a much smaller percentage of capital to implement much larger hedges.
You can read more from Darrel’s article on the TradingMarkets.com website by clicking here.