How To Survive A Drop In Stocks And Bonds By Using A Short Copper Position As A Synthetic Put Option

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Includes: TMF, UPRO, XIV
by: Harry Long

Summary

This index got a massive response from readers.

It was built to survive extreme scenarios.

Adding a short copper position further hedges the portfolio.

Short copper acts like a synthetic put option.

And it further decreases the correlation of the portfolio to equities and to fixed income.

By pairing short vol, long equity, and long duration government bond exposure with a short copper position, we have an interesting tail hedge. Even when copper rises, in a risk off regime, the inverse volatility position skyrockets, allowing us the possibility of profits even in a strong economy in which construction demand causes copper to skyrocket.

Here are the index's rules:

I. Buy VelocityShares Daily Inverse VIX Short-Term ETN (XIV) with 10% of the dollar value of the portfolio.

II. Buy ProShares UltraPro S&P 500 ETF (UPRO) with 35% of the dollar value of the portfolio.

III. Buy Direxion Daily 30-Year Treasury Bull 3x Shares ETF (TMF) with 35% of the dollar value of the portfolio.

IV. Short the Copper ETF (JJC) with 20% of the dollar value of the portfolio.

V. Rebalance weekly to maintain the 10%/35%/35%/20% dollar value split between the instruments.

Here are the results:

It is important to understand the reasoning behind this strategy. We should first separate the strategy into its return generating and its hedging components. Its short volatility and leveraged S&P positions act as the return generating components. The longs leveraged government bond and short copper components act as hedges. Because longs bonds and short copper are negatively cointegrated to equities, they act as a hedge in times of economic uncertainty.

The results are superb, but the copper hedge acts as best as a hedge in an extreme 2008-2009 scenario. The economic sensitivity of copper causes it to be an excellent synthetic put option on the economy. However, there is no reason to have on the copper position when it is in backwardation. In any backwardation scenario, the 20% short allocation to copper should be moved to cash.

The major weakness of the strategy is that long bonds and short copper are good statistical hedges, but they are imperfect. They might not fully offset declines in XIV and UPRO. However, from an asset allocation view point, this portfolio is far more diversified than conventional stock bond mixes.

Remember, shorting should not be attempted by inexperienced investors. This is a sophisticated strategy which should be contemplated carefully.

I hope I have provoked some lively discussion of the advantages of synthetic hedges.

Thanks for reading.

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Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in XIV, TMF over 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.