Hedged Bets Against Oil, China Illustrate An Alternate Approach To This Market

by: David Pinsen


One frequently proposed method of investing during a correction, buying high-yielding dividend stocks, is analogous to trying to catch falling knives.

We describe an alternative approach here, one that uses an agnostic approach to security type, buys what's going up, and hedges against it going down.

We elaborate on the method and offer a sample portfolio that includes promising stocks as well as bearish bets on China and oil.

Catching Falling Knives

With the market off to one of its worst starts to a year ever, a number of articles about how to invest now have focused on buying dividend stocks. These articles generally rely on two ideas:

  1. Since share price is the denominator in the dividend yield calculation, you can get a higher yield by buying dividend-paying stocks "on sale".
  2. The author "isn't worried" about share prices; he's attention is on the income generated by his dividend stock portfolio.

There are some issues with this approach. One is that, if the correction persists, you could quickly lose more in principal than you stand to gain from dividends. Pseudonymous stock trader "StockCats" made this point pithily on Twitter (NYSE:TWTR) on Tuesday:

A second issue is that like all stocks, higher-yielding, dividend-paying stocks can suffer catastrophic declines. As we detailed in a recent article, according to a JP Morgan (NYSE:JPM) study, since 1980, 40% of stocks suffered catastrophic declines of 70% or more, without recovering. Buying falling stocks can be like trying to catch a falling knife (image below by Jonathan Collum, via 13pt.com).

An Alternative Approach

An alternative approach is to buy things that look like they are going up, and hedge against them going down. That, in a nutshell, is what the hedged portfolio method does. We showed how you can implement that method on your own in a previous article. In this one, we'll highlight an aspect of the way Portfolio Armor constructs hedged portfolios that you may want to consider given the current market environment.

Agnostic Security Selection

Instead of limiting itself to stocks, Portfolio Armor is agnostic about whether a security is a stock or an exchange-traded product such as an ETF. Further, with respect to ETFs, it's agnostic about whether they are inverse or not, and whether they are leveraged or not. All the site considers is what the security's potential return is over the next several months, and how expensive it is to hedge while being positioned to capture that potential return. It then ranks its securities by potential return net of hedging cost ("net potential return"), and uses the ones with the highest net potential returns to populate hedged portfolios.

Agnostic Security Selection During An Inflection Point

Before the recent correction started, the top 10 names in the site's universe, when ranked by net potential return, were almost always stocks. Now, though, two levered inverse ETFs have climbed into the top-10: The ProShares UltraShort Bloomberg Crude Oil ETF (NYSEARCA:SCO), which is a levered -2x bet on crude oil, and the Direxion Daily FTSE China Bear 3x Shares (NYSEARCA:YANG), which is a levered -3x bet on the FTSE China 50 index. You can see this in the hedged portfolio below, which is what the site would have presented you as of Tuesday's close, if you told it you had $200,000 to invest and were unwilling to risk a decline of more than 18% over the next six months.

Why These Underlying Securities?

If a person had put together this portfolio, you'd probably assume he included YANG and SCO because he knew that plummeting oil prices and weakness in China have led the current market correction, and he added those bearish ETFs to balance out his primary positions in the stocks Activision Blizzard (NASDAQ:ATVI) and NVIDIA (NASDAQ:NVDA). That way, if the correction continues, chances are, at least he'd make money on YANG and SCO.

But a person didn't construct this portfolio; a computer program did, one that is agnostic about types of underlying securities. It picked these securities because they had among the highest net potential returns in its universe on Tuesday. In the fine-tuning step of its portfolio construction process, it allocated the leftover cash from the rounding down to round lots of YANG, SCO, ATVI, and NVDA to Amazon (NASDAQ:AMZN), which it added as what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications (in this case, to a drawdown of no more than 18%).

Let's turn our attention now to the portfolio-level summary, starting with the most important part for risk management purposes.

Worst-Case Scenario And Hedging Cost

The "Max Drawdown" column in the portfolio level summary shows the worst-case scenario for this hedged portfolio. If every underlying security in it went to zero before the hedges expired, the portfolio would decline 16.68%. Max Drawdown includes positive hedging cost, but not negative hedging cost. Since the hedging cost here is -3.25%, and 16.68% - 3.25% = 13.43%, the investor would only be down 13.43% in the worst case scenario (if each of the underlying securities went to zero before their hedges expired).

Best-Case Scenario

At the portfolio level, the net potential return is 17.71%. This represents the best-case scenario if each underlying security in the portfolio meets or exceeds its potential return.

A More Likely Scenario

The portfolio level expected return of 6.97% represents a more conservative estimate, based on the historical relationship between our calculated potential returns and actual returns.

Each Security Is Hedged

Note that in the portfolio above, each underlying security is hedged. In this case, they're each hedged with collars, but the site will hedge with puts instead if it can get a higher net potential return by doing so. Below is a closer look at the optimal collar hedge for the levered bearish bet against oil, SCO.

As you can see in the section of the screen capture above (image via the Portfolio Armor iOS app), this collar is capped at 20%. That's because that's the potential return the site calculated for the ETF over the next several months. The cost of the put leg of the collar was $3,190, or 14.83% of position value. However, if you look at the section of the screen capture below, you'll see that the cost of the put leg was more than offset by income of $4.960, or 23.07% of position value, from the short call leg.

So the net cost of this collar was -$1,770 or -8.23% as a percentage of position value. Note that, to be conservative, the cost here was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less (at some price between the bid and ask), and sell calls for more (again, at some price between the bid and the ask), so the actual cost of this hedge would likely have been less. The same is true of the other hedges in this portfolio, as they were calculated in a similarly conservative manner.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.