Market Neutral 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.
Market Neutral 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 hedging schedules in order to create a market neutral portfolio and traders must decide which, if any, to utilize.
In order to implement a hedge with a portfolio in The Machine, the user must first decide the type of schedule to maintain. 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.
The third step is to decide whether to institute a 50% hedge or a 100% hedge.
Once users have made these selections, they may now decide whether they want to apply the hedge to all strategies within their portfolio – or only selected strategies.
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.
In order to utilize Market Neutral 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 long or short exposure was 100%.
Once the initial hedge is in place, daily rebalancing is 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).
Market Neutral Hedging ensures that the portfolio is always market neutral on a dollar basis. This helps to protect portfolio against the downside risk associated with a net long position or the upside risk associated with a net short position.
One additional note for IRA portfolios or for others who may not have sufficient cash on hand, would be the use of futures contracts. A single mini index futures contract could hedge approximately $60,000 of holdings and the commission overhead is next to nothing. Further, mini futures can be margined using approximately 8% of their contract value. This means they would occupy approximately 4% of portfolio equity (in cash) if implementing the 50% hedge. Most importantly, short futures are permitted inside IRAs. And finally, futures function very efficiently as hedges. That is why they were created initially.
Click here to learn more about trading with the historically-backed trading strategies developed by Larry Connors and Connors research. Start trading your portfolio with a scientific approach today.