Seeking Alpha

Hedging Stock Market Risk: Part 1

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Includes: TAIL
by: Robert Boslego
Robert Boslego
Portfolio strategy, oil & gas, medium-term horizon
Summary

Current bull market is getting old.

Stock market risk can be hedged with puts.

PUTT index provided superior risk-reward results 1986-2019.

TAIL provided superior risk-reward results 2017-2019.

But maximum drawdown was still too high.

The current bull market in stocks began on March 9, 2009. At about 128 months old, this bull is one for the record books.

I am not forecasting the end. I think it is foolish to try to pick the turning point in advance. But it may also be foolish expecting it to last a lot longer.

Instead, I use an algorithm I designed called Vertical Risk Management (VRM). It is based on a behavioral finance concept developed by Nobel laureate Robert J. Shiller. In this paper, he discusses the failure of the efficient markets theory to explain stock market prices and the "blooming of behavioral finance." In particular, he describes one of the oldest theories about financial markets, which he calls price-to-price feedback theory. Essentially, he argues that the emotions of greed and fear drive market prices far too high on the upside, and much too low on in downturns. My discussion of this approach is discussed in my Seeking Alpha article here.

And so, I began investigating strategies that might outperform a straight long S&P 500 strategy. One way to hedge a long position is to add puts. Another way is to add covered calls. A third way is to add both.

Puts can prevent major losses in a down market but come at a cost, the premium paid. Calls can soften the impact of a down market by collecting premiums, but they also reduce upside potential.

I assessed all three strategies using index returns from the Chicago Board Options Exchange (CBOE) from July 1986. In this Part 1, I examine the use of puts. In Part 2, I examine the use of calls. And in Part 3, I examine the use of puts and calls together, as well as sum up the results.

I also examine the use of Cambria Tail Risk ETF (TAIL) in Part 1. It has a much shorter trading history (since April 2017), and so the analysis is somewhat limited. Read Meb Faber’s paper for a discussion of TAIL.

SPX Risk and Return

SPX is an index of the S&P 500. That means that it is calculated directly by the value of the underlying stocks. SPY is an ETF, which means its price is set by buyers and sellers of the ETF. Note that indexes are not investable.

CBOE provides a history of the index from July 1986 through July 2019. Over that period, an initial $1,000 investment would have increased to $12,063.

There are many techniques used to measure investment risk. The one I find most important is maximum drawdown from peak. The reason is that it shows how much (percentage) an investment had lost from its “high water mark.” Based on investor behavior and hedge fund practice, this is a risk tolerance limit wherein an investor would consider exiting the investment. In the hedge fund industry, this limit is typically set at 30 percent; i.e., any “lock-up” of capital is released if that limit is reached (or exceeded). The best investments are those in which an investor can remain for the long term rather than locking in losses by exiting.

For SPX, the maximum drawdown from peak over this period was 57 percent on March 9, 2009. This is obviously a very large loss which is why risk management is needed.

Cboe S&P 500 5% Put Protection Index (PPUT)

The CBOE S&P 500 5% Put Protection Index (PPUT) is a benchmark index designed to track the performance of a hypothetical risk-management strategy that consists of a long position indexed to the S&P 500 Index (SPX Index) and a rolling long position in monthly 5% Out-of-the-Money (OTM) SPX Put options. The PPUT Index rolls on a monthly basis, typically every third Friday of the month.”

Read this paper for Index Design and Calculation.

Calculating the return of PUTT over the same period as above, the value of PUTT rose to $9,594. The return of SPX alone was 26 percent higher.

But the maximum drawdown of PUTT was 42 percent. The maximum drawdown of SPX was 35 percent higher.

The question becomes what if I just reduce the size of my portfolio to reduce the maximum drawdown to that of PUTT? To reduce the maximum drawdown to 42 percent, the SPX portfolio would have to be reduced to 68 percent of its initial size. But that would reduce the final value of the SPX portfolio to $6,115, which is only 64 percent of the ending value of PUTT.

I therefore conclude that PUTT offers a better risk-reward tradeoff if maximum drawdown is used as the risk criterion. However, I also conclude that 42 percent is still too high of a loss for most investors to tolerate.

Cambria Tail Risk ETF (TAIL)

As previously noted, the CBOE indexes are calculations and not investable. Cambria Capital, LLC created a tail-risk management ETF that began trading in early April 2017.

I combined SPX and TAIL in hypothetical portfolios through July 2019 to assess the performance, varying from 100% SPX and 0% TAIL to 0% SPX and 100% TAIL.

SPX 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
TAIL 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Final Value $ 1,284 $ 1,237 $ 1,190 $ 1,144 $ 1,097 $ 1,051 $ 1,004 $ 959 $ 914 $ 869 $ 826
MAX DD 20% 16% 12% 8% 5% 4% 6% 9% 13% 17% 21%
Ch Value -4% -7% -11% -15% -18% -22% -25% -29% -32% -36%
Ch MAX DD -19% -38% -57% -74% -79% -71% -56% -36% -16% 4%

Since TAIL is a put strategy, it is like buying insurance, and the cost of insurance has an expected negative value, just as insurance has an expected positive value to the underwriters.

Over this short period, when the stock market was appreciating, the value of SPX alone went up 28% but had a maximum drawdown of 28 %. Adding TAIL to the portfolio reduced the maximum drawdown to only 4% at the optimal mix, and it reduced final value relatively less than it reduced the risk measurement. Therefore, it offered a superior risk-reward tradeoff in my opinion.

Conclusions

Hedging with puts offers an improved risk-reward trade-off based on the data series tested above. However, the PUTT index still resulted in a maximum drawdown during the financial crisis of 2008-2009 than would be tolerable for many investors. And so I will present the findings of using a covered call strategy in Part 2 of this series and the result of using put and call strategies in Part 3.

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.