hedging tactics & other risk management techniques …files.meetup.com/1621769/falcon global...

Hedging Tactics & Other Risk Management Techniques

– Protecting Your Dream

Copywrite 2016 Falcon Global LLC 2

•Robyn Mendel's slide deck posted to Meetup file archive.http://www.meetup.com/Chicago-NW-Burbs-Trading-Club/files/

•Video posted to Meetup.http://www.meetup.com/Chicago-NW-Burbs-Trading-Club/pages/CNW_Burbs_Meetup_Video_Archives/

•Greentradertax – trader tax specialisthttps://www.greentradertax.com/

Follow up from last meeting

http://www.meetup.com/Chicago-NW-Burbs-Trading-Club/files/

http://www.meetup.com/Chicago-NW-Burbs-Trading-Club/pages/CNW_Burbs_Meetup_Video_Archives/

https://www.greentradertax.com/


•Trading since about 2000, after joining an Investools stock class. Increased activity in 2009 when my company was acquired and saw the need for creating MSI (multiple streams of income).

•Wyeth Pharmaceuticals (worked up through the ranks from a new pharmaceutical representative, Rheumatology Specialty Manager, Hospital Accounts Manager, District Manager, Midwest Regional Manager).

•Full time self directed investor and trader since June 2013.•Founded along with 2 partners Falcon Global Traders December 2013.

o Goal: To become a better self directed investor/ trader and to continue to exercise my coaching muscles.

o Motto: Where Traders Find Edge from Entry to Exit

Stephen’s Bio:


•Setting the Stage

oPortfolio Strategy and it’s Role

oBusiness Cycle and Key Indicators

oAssessment of Risk

oCorrection Backgrounder

oHedge Funds Backgrounder

•Hedging Tactics

Objectives:


• College English literature

• Business – Best Practices

• Key influences would include Investools, John Carter & crew, Sheridan, OTA, and many others.

• Trading – learn & adapt to your style.

• My sources; a melting pot of many primary sources to which I readily adapt to my purposes.

A Comment About Sources:


•What are we trying to achieve?

•What kind of portfolio do we have?

•Highly personal

•Personal risk tolerance

Goal Setting:


•Optimize growth and reduce risk by decreasing portfolio volatility to turbo boost total performance.

•Recognition that the goal is not necessarily to beat the market each 1 year interval but to produce consistent strong performance.

•Seek to allocate and have non-correlated assets in creating a well-balanced portfolio.

•Dynamically re-balance using a tactical asset allocation model with hedging.

•Apply multiple time frames across all asset classes such as stocks, bonds, commodities, REIT, countries, and currencies and divide assets among stock sectors, industry groups, and capitalizations.

•Effectively address volatility to enhance consistent performance and minimize drawdowns.

Portfolio Goal Example:


•http://www.falconglobaltraders.com/about-falcon-global

Portfolio Strategy eBook from Falcon Global

http://www.falconglobaltraders.com/about-falcon-global


Portfolio Strategy eBook from Falcon Global


oUnsystematic or diversifiable

oSystematic or non-diversifiable

Portfolio Risk Management


oCan be managed

oBusiness/ financial risk

oDefault/ credit risk

oEvent risk

oPolitical risk

oLiquidity risk

Unsystematic or Diversifiable


oMuch harder to manage

oPurchasing power (bonds)

oReinvestment rate risk (bonds)

oInterest rate risk (bonds & REITs)

oMarket risk – the primary systematic risk for our portfolios

oExchange rate risk – global currency impacts

Systematic or Non- Diversifiable


o Widow in bondso Widow in a basket of stocks

o MDT, SHW, LOW, WMT, VFC, ECL, HRL, BDX, JNJ are dividend aristocratso WMT is also a MOAT company

Case Studies:


•Goal: to apply diversification to minimize unsystematic risk, the

right mix of assets, and time

•Evolutionary development

o Grandfather – 20 stocks across various industries

o WWII generation – mutual funds

o Profile – financial planners template; 2030 fund

o Modern Portfolio Theory

Asset Allocation Models


•Tactical asset allocation

oUses fundamental and technical analysis to time when changes are made

o% of stock allocation

o Sector rotation

o Inter-market analysis

oActive style used to improve portfolio returns

oRequires higher level of knowledge

oAdjusted quarterly, monthly, or bi-weekly

o “Smart Beta ETFs” are some of the fastest growing in the ETF space

Modern Portfolio Theory


•Blended approach

ouses 70 – 80% with fixed allocation and the remaining for alternative strategies such as sector rotation, options, and futures



•Dynamic asset allocation plan

oUse of a tactical asset allocation along with portfolio hedging

oCurrently < 1% of self directed investors

oExpected to grow as education and awareness grows

oPortfolio hedging – used by hedge fund managers & professional money managers

Constructed a balanced, diversified, & hedged portfolio which is designed to limit downside losses



•Dynamic asset allocation plano Driven by understanding that capital lost is capital that cannot grow

“The winds and waves are always on the side of the ablest navigators” Edward Gibbon



•Hedged will NOT outperform in the short term, built to outperform in the long term•Creates greater sense of comfort especially during difficult market periods

•The ten worst days ranged from -5.22% to -9.84%. Eight of these days occurred in the second half of 2008. The mean of the ten worst days was -6.88%. Simply having a timing model in place to take you to cash during severe downturns could have placed you on the sidelines during much of this stressful period.•$100,000 invested in the S&P 500 on 1/1/2001 would have been worth $113,692 on 12/31/2010.•$100,000 invested in the S&P 500 on 1/1/2001 with no loss on the ten worst performing days would have been worth $232,360 on 12/31/2010.•The four worst quarters were the ending December 2008, September 2008, June 2002, and September 2001. The average loss for these quarters was -16.5%.

Dynamic Asset Allocation Plan


•Buy and hold for a Japanese investor is even worse which is a highly developed economy that this country once feared.

•Remember the news stories that the Japanese were going to own America and that they were going to take all the market share from the American industrial segments.

•From the Japanese market peak to the bottom you would be down 75% the value of your portfolio.

•If you had continued to hold through the bottom you are today ONLY 50% DOWN from the peak. How long will the buy and hold investor have to wait for the Japanese market to provide a real return? A real return adjusted for inflation?

Another Mature Financial Market Example - Japan


Risk On, Risk Off


•Seek a mix of asset classes with differing levels of correlation

•Diversified portfolio can be more aggressive in the setting of hedge as some of risk is managed through diversification

Correlation


• -1 = inversely correlated

• 1 = perfectly correlated

• 0 = random or not correlated at all

• > .5 is too correlated

Correlation Emerging Markets & U.S. Equities – more correlated than you might expect!


Fund Ticker Correlation

SPDR Select Sector Fund - Industrial XLI 0.944

SPDR Select Sector Fund - Consumer Discretionary XLY 0.931

SPDR Select Sector Fund - Technology XLK 0.921

Materials Select Sector SPDR XLB 0.911

SPDR Select Sector Fund - Financial XLF 0.897

SPDR Select Sector Fund - Energy Select Sector XLE 0.863

SPDR Select Sector Fund - Health Care XLV 0.792

SPDR Select Sector Fund - Consumer Staples XLP 0.754

SPDR Select Sector Fund - Utilities XLU 0.407

http://www.sectorspdr.com/sectorspdr/tools/correlation-tracker?c_3-orderBy=Name-asc

http://www.sectorspdr.com/sectorspdr/tools/correlation-tracker?c_3-orderBy=Ticker-asc

http://www.sectorspdr.com/sectorspdr/tools/correlation-tracker?c_3-orderBy=Correlation-asc


Sector Variability

•Credit Bloomberg


Sectors Lead & Lag

•Credit Fidelity Investments


•Portfolio is anchored in the long term.

•Critical to have an understanding of the driving economic factors with the business cycle.

•With awareness arises the ability to discern opportunity and apply probabilities to identifiable economic phases and optimize asset allocation.

•Utilization of trend & technical analysis to identify turning points.

Business Cycle:


•Credit Stockcharts.com

Classic Business Cycle:


•Credit Investools

Business Cycle Phases:



Inflationary Pressures & Economic Sensitivity:


•Not uniform

•2 – 10 years

•Since 1945

• 11 cycles

• Average of 5.7 years

Business Cycle Characteristics:


•Avg. downturn of 15%

•Avg. duration is 10 months

•Interest rates peak, corporate defaults, overexpansion, value loss, deleveraging, hard to obtain credit, and falling inventories even with low sales

•Losses across the board

•Your primary goal becomes protection of trading capital

•Consumer staples, utilities, telecom, and healthcare hold up the best and are the best places to stick toes in the water (perhaps put selling or ITM covered calls)

•High yield bonds have high economic sensitivity – will behave more like investment grade bonds in this phase

Recessionary Phase Characteristics:



Industry Level Analysis Necessary:Recession Phase



Asset Class Performance by Cycle Phase – 1950 to 2010


•Credit Investools

Normal Cycle


•GDP

•Inflation & interest rates (CPI and PPI)

•Employment

•Others include:

•Housing (Housing Starts, Existing Home Sales, Pending Home Sales)

•Consumer Sentiment (includes Retail Sales, Personal Income, & others)

•Industrial Production (Durable Goods Orders, ISM, & others)

•International Trade (Trade Balance, International Trade Report)

•Government (Discount Rate and Open Market Operations)

Key Macroeconomic Indicators


•Commodities & dollar

•Commodities & bond yields

•Yield curve

•Key ratios:

•Excerpt from Monthly Portfolio Strategy Ratio Report

Inter-market Analysis


•How long has the current bull market lasted vs. norms?

• (graph as of early 2015)

•Current bull market is 82 months long

Recessionary Tells

Median = 43 months


•Macroeconomic indicators

Recessionary Tells



Recessionary Tells



•Falcon Global’s Monthly Portfolio Strategy Report compiles & reviews:

•“Big 4” +1• GDP

• CPI

• PPI

• Unemployment

• Yield Curve

• Bear Market Indicator Group• Basket of 6 key business cycle indicators with strong track records

to demonstrate elevated risk levels that often precede Bear Markets

Recessionary Tells


Late Bull Markets can Still Be Powerful


•It is all about not losing capital in the bear markets

•Theoretical Bear Market from recent DJIA top

o Average Bear Market Decline = 33.5% drawdown

o Dow 18,000 goes to DOW 12,000 over a few months period

o Can take years to get back to even if you ride it out

2008 rollover to 2009 bear market bottom took 3 years to get back to even

Recessionary Impact to Portfolio


•Measuring risk / standard deviation & beta

•Thresholds for

Hedge

Activation

Trigger

Market Timing


•Part of member subscription - complete review of key macro-economic indicators to develop consensus opinion of where we are in the current business cycle.

•Share periodically some highlights in the Bloomingdale meeting.

Market AwarenessMonthly Business Cycle Analysis


•My opinion of current market trends, market timing, volatility, and hedge risk levels for U.S. markets

•https://www.youtube.com/c/Falconglobaltraders

•Free to subscribe to YouTube channel/ subscribers get notice when content is published

•About 10 – 20 minutes published usually by 7:30 AM Central each trading day

Market AwarenessDaily Market Preview Analysis

https://www.youtube.com/c/Falconglobaltraders

Market AwarenessNews that can shape markets

Falcon Global on Social Media

@FalconGlobalLLC

FalconGlobalLLCTraders

StockTwits FalconGlobalTrader

Scutify @StephenHarris

subscribe to the channel!


Correction Backgrounder - Definitions


Black Swan Definition

An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. This term was popularized by Nassim Nicholas Taleb, a finance professor and former wall street trader.


• S&P 500 corrections of 10% or more, including those that turned into bear markets, occur nearly every 1.5 years (357 trading days) on average since 1957. The last correction began over two years ago (550 trading days) in the summer of 2011, but that correction was severe and nearly a bear market with a 19% decline. But more importantly, there is enormous variation around the mean of trading days between corrections. The STD is higher than the mean, thus a correction is not more than 80% likely, based on precedent since 1957, until 750 days from the last correction. Moreover, corrections are less frequent the past 25 years vs. the past 50+ years. From 1990 to 1997 the S&P avoided a 10%+ decline (1994 was close), also from April 2003 to September 2007. Thus 4 years without a correction is possible, especially if earnings climb and inflation and interest rates stay low vs. history, but a higher PE raises the risk.

Correction Backgrounder



http://static1.businessinsider.com/image/52b0d572ecad04164649d772-960/cotd-96.jpg

http://static1.businessinsider.com/image/52b0d572ecad04164649d772-960/cotd-96.jpg


* Since the end of World War II (1945), there have been 28 corrections of 10% or more, 12 of which had turned into full-blown bear markets (with losses of 20% +).

* This equates to one correction roughly every 20 months, according to Dow Jones index maven John Prestbo, who points out that this average does not mean they’re evenly spaced out. 25% of these corrections over the last 66 years occurred during the 1970′s (the Golden Age of Market Timers), another 20% occurred during the secular bear market of 2000-2010.

* The average decline during these 27 episodes has been 13.3% and they’ve taken an average of 71 days to play out (just over three months).



* From the beginning of the last secular bull market in 1982 through the 1987 crash, there was just one correction of 10% or more. Between the Crash of 1987 and the secular bull market’s peak in March 2000, there were just two corrections, according to Ed Yardeni. This means that secular bull markets can run for a long time without a lot of drama.

* Since the stock market’s bottom in March of 2009, there have been only 4 corrections: In the spring of 2010 the S&P 500 began a 69-day drop of roughly 16%. The widely referenced summer correction of 2011 lasted for about 154 days and almost became a bear market. The correction during the spring of 2012 set up one of the greatest rallies of all time, although it was barely a real correction, sporting a peak-to-trough drop of just 9.9% in just under 60 days.



• Prior to the August 2015 correction, the most recent correction took place in 2011, between the end of April into the end of September. The Dow dropped roughly 16%. The S&P 500 actually dropped a hair over 20% before snapping back, leading some to believe that this was a bear market – the implication being that the current bull market is much younger.

* Bull market rallies in between corrections – and there have been 58 in the post-war period – tend to run for an average of 221 trading days before being interrupted and gaining an average of 32%.



* As to what we should do during corrections, I’d recommend maintaining a list of high-quality stocks you’ve been kicking yourself for missing out on and clearing the decks of any longs you don’t truly love. For those with time horizons longer than five years (most), the best thing to do is grit one’s teeth and do very little. If a correction of between 10 and 20% is unbearable to you mentally or financially, that means you’ve either got more money than you should invested in stocks or you’re not balanced to your real level of acceptable risk. Make the adjustment you can live with and remember this feeling the next time you find yourself chasing the market.

* As to the question of whether a correction could become a bear market (or worse even, a crash), the answer is that this is always possible. But most corrections do not become crashes, and every single one of them turned out to have been great buying opportunities in the fullness of time.



• The quickest correction was 18 calendar days in 1955 while the longest was 531 from September 1976 to March 1978. The longest the S&P 500 went without a 10% correction was 2553 calendar days from October 1990 until October 1997. The second longest streak without a correction occurred in the last bull market that ended in 2007 when the S&P 500 went 1673 days. The fewest number of days between corrections was 35 in 1974.

Recent S&P 500’s streaks of more than 1000 days without a correction is nearly twice the average number of days between past corrections, but unlike past streaks of similar or greater length, the current streak is most likely the result of unprecedented Fed liquidity rather than actual economic performance. Based upon past corrections, the current streak could easily last much longer or it could just as easily end any day.



• Stock market corrections are an inevitable part of investing.

• They’re also the last thing most investors want to experience.

• Here is some historical background to help you put market declines in perspective.

Correction Backgrounder- What past market declines can teach us


Correction Backgrounder- A history of declines (1900–12/2013)

Type of decline Average frequency1 Average length2 Last occurrence Previous occurrence

–5% or more About 3 times a year 47 days October 2013 August 2013

–10% or more About once a year 115 days October 2011 July 2010

–15% or more About once every 2

years

216 days October 2011 March 2009

–20% or more About once every 3 ½

years

338 days March 2009 October 2002

Events Average Change% Average Duration (Months) Average Recovery (Months)

Pullbacks (5 - 10%) 54 7% 1 2

Corrections (10 - 20%) 19 14% 5 4

Bear markets (20+%) 12 28% 14 23


Correction, That’s Nothing; What about Crashes

1962 Flash Crash (U.S.) 28-May-62

Black Monday 19-Oct-87

Friday the 13th mini-crash 13-Oct-89 Failed leveraged buyout of United Airlines causes crash

1990-1991 Recession Jul-90Iraq invaded Kuwait in July 1990, causing oil prices to increase. The Dow dropped 18% in three months, from 2,911.63 on July 3 to 2,381.99 on October 16,1990. This recession lasted approximately 8 months.

October 27, 1997 mini-crash 27-Oct-97Global stock market crash that was caused by an economic crisis in Asia. The points loss that the Dow Jones Industrial Average suffered on this day still ranks as the eighth biggest point loss in its 117-year existence.

Dot-com bubble 10-Mar-00 Collapse of a technology bubble, world economic effects arising from the September 11 attacks and the stock market downturn of 2002.

Economic effects arising from the September 11 attacks 11-Sep-01

The September 11 attacks caused global stock markets to drop sharply. The attacks themselves caused approximately $40 billion in insurance losses, making it one of the largest insured events ever.

Stock market downturn of 2002 9-Oct-02

Downturn in stock prices during 2002 in stock exchanges across the United States, Canada, Asia, and Europe. After recovering from lows reached following the September 11 attacks, indices slid steadily starting in March 2002, with dramatic declines in July and September leading to lows last reached in 1997 and 1998.

United States bear market of 2007–2009 11-Oct-07 Till June 2009, the Dow Jones Industrial Average, Nasdaq Composite and S&P 500 all experienced declines of greater than 20% from their peaks in late 2007.

Late-2000s financial crisis 16-Sep-08

On September 16, 2008, failures of large financial institutions in the United States, due primarily to exposure of securities of packaged subprime loans and credit default swaps issued to insure these loans and their issuers, rapidly devolved into a global crisis resulting in a number of bank failures in Europe and sharp reductions in the value of equities (stock) and commodities worldwide. The failure of banks in Iceland resulted in a devaluation of the Icelandic króna and threatened the government with bankruptcy. Iceland was able to secure an emergency loan from the IMF in November. Later on, U.S. President George W. Bush signs the Emergency Economic Stabilization Act into law, creating a Troubled Asset Relief Program (TARP) to purchase failing bank assets.

2010 Flash Crash 6-May-10

The Dow Jones Industrial Average suffers its worst intra-day point loss, dropping nearly 1,000 points before partially recovering.

August 2011 stock markets fall 1-Aug-11 Stock markets around the world plummet during late July and early August, and are volatile for the rest of the year.

http://en.wikipedia.org/wiki/1962_Flash_Crash

http://en.wikipedia.org/w/index.php?title=1990-1991_Recession&action=edit&redlink=1

http://en.wikipedia.org/wiki/Dot-com_bubble

http://en.wikipedia.org/wiki/Economic_effects_arising_from_the_September_11_attacks

http://en.wikipedia.org/wiki/September_11_attacks

http://en.wikipedia.org/wiki/Stock_market_downturn_of_2002

http://en.wikipedia.org/wiki/United_States_bear_market_of_2007%E2%80%932009

http://en.wikipedia.org/wiki/Late-2000s_financial_crisis

http://en.wikipedia.org/wiki/2010_Flash_Crash

http://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average

http://en.wikipedia.org/wiki/August_2011_stock_markets_fall


• No one can predict consistently when market declines will happen.

It’s easy to look back today and say with hindsight that the stock market was overvalued at a particular time and due for a decline. But no one has been able to accurately predict market declines on a consistent basis. In January 1973, a New York TimesSM poll of 8 market authorities predicted that the market would “move somewhat higher” in the future. The Dow industrials proceeded to decline 45% over the next 23 months. Then, although almost no one predicted it, the Dow rose 38% in 1975.

Correction Backgrounder - What lessons can we learn from past market declines?


• No one can predict how long a decline will last.

Since 1982, with few exceptions, market declines have been relatively brief. Earlier market declines have lasted longer. After the 1929 crash, it took investors 16 years to restore their investments if they invested at the market high. In 2000, it took about 5 years. But after the 1987 crash, it took about 23 months to get back. In 1990, it took about 8 months. All cases assume dividends were reinvested.



• No one can consistently predict the right time to get in or out of the market.

Successful market timing during a decline is extremely difficult because it requires 2 near-perfect actions: getting out and then getting back in at the right time. A common mistake investors make is to lose patience and sell at or near the bottom of a downturn. But even if you have decent timing and get out early in a decline, you still have to figure out when to get back in. A bear market is not usually characterized by a straight-line decline in stock prices. Instead, the market’s downward trend is likely to be jagged —showing bursts of stock price increases, known as “sucker’s rallies,” and then declines.



• Living with a market decline isn’t easy, but if you understand these lessons, you’ll be a more intelligent investor.



What Does Volatility Tell Us?

Increasing VolatilityChart


What Does Volatility Tell Us?

DecreasingVolatilityChart


Correction Backgrounder – Vol Spikes


• It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same -- investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.

Synopsis of Hedge Fund Strategies


Many, but not all, hedge fund strategies tend to hedge against downturns in the markets being traded.

Hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.). Mutual funds are often limited.

Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business.

Key Characteristics of Hedge Funds


Estimated to be a trillion dollar industry, with about 8350 active hedge funds.Includes a variety of investment strategies, some of which use leverage and derivatives while others are more conservative and employ little or no leverage. Many hedge fund strategies seek to reduce market risk specifically by shorting equities or derivatives.Most hedge funds are highly specialized, relying on the specific expertise of the manager or management team.Performance of many hedge fund strategies, particularly relative value strategies, is not dependent on the direction of the bond or equity markets -- unlike conventional equity or mutual funds (unit trusts), which are generally 100% exposed to market risk.Many hedge fund strategies, particularly arbitrage strategies, are limited as to how much capital they can successfully employ before returns diminish. As a result, many successful hedge fund managers limit the amount of capital they will accept.Hedge fund managers are generally highly professional, disciplined and diligent.Their returns over a sustained period of time have outperformed standard equity and bond indexes with less volatility and less risk of loss than equities.Beyond the averages, there are some truly outstanding performers.Investing in hedge funds tends to be favored by more sophisticated investors, including many Swiss and other private banks, who have lived through, and understand the consequences of, major stock market corrections. Many endowments and pension funds allocate assets to hedge funds.

Facts About the Hedge Fund Industry


• The popular misconception is that all hedge funds are volatile -- that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities, and gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds like Quantum, Tiger, and Strome.

• Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Popular Misconception


• Aggressive Growth

• Distressed Securities

• Emerging Markets

• Fund of Funds

• Income

• Macro

• Market Neutral

• Market Timing

• Opportunistic

• Multi Strategy

• Short Selling

• Special Situations

• Value

Hedge Fund Strategies


• Your portfolio strategy matters …

• Your risk tolerance matters …

• Your understanding of pullbacks, corrections, and bear markets matter…

• Your attitude towards hedging matters …

• Your ability to make decisions sometimes under stress, your judgement, and your level of engagement will all impact what you will ultimately decide is right for you in your approach to hedging.

• Understanding the tools of the trade for hedging build confidence to apply the right tool to the right situation.

So Where are We Now?


• What do you want to hedge?

• What is your risk profile?

• How much to hedge?

• When to hedge?

• How much time do you need your hedge?

• When to exit your hedges?

Hedging Basics


• Sometimes easier to think of what may not need to be hedged?

o Defined risk positions such as option spreads, option income

o Bond positions

o Stock positions that are already hedged with long puts etc.

• What is your risk?o Understand how to use your analysis tab and to segregate what you

need to evaluate risk on.

o 11 level risk profile

• How much to hedge?o Personal judgement influenced by level of current market risk

opinion.

What do You Want to Hedge?


• Time frame matters

• Different tactics for long term, intermediate, and short term hedging

• Long term – months

• Intermediate term – weeks to months

• Short term – intraday - days

When to Hedge?


• You need a systematic method to determine your market posture and risk level assessment.

• Needs to be as objective as possible, emotion rides high when the market is under stress, as are you!

• 0 – 3 system with 3 being the highest.

• I will utilize + as half step increments sometimes.

• What does a hedge risk opinion mean?

• Rules defined system with some judgement applied to come up with a daily hedge risk level.

• Can use my system, someone else’s opinion, or your own but have a system!

• Remember it is an opinion, and only you know your own risk tolerance and financial situation.

Risk Opinion


• Risk management begins with smart target selection.

• Every trade starts with a predefined target and decision point stop loss.

• Remove risk whenever appropriate.

• Understand the return on capital per day in trade concept.

• Utilize closing orders to remove risk on any shorts.

• Consider 80% of maximum profit target objectives for short option trades.

• .05 closing orders

• Uncorrelated diversification strategies for core portfolio.

• Inverse ETFs such as SH.

Long Term Hedging Tactics - SOP


• Actions:

o Simply following standard operating procedures

o Setting up passive long term & intermediate term hedges when volatility is low.

Hedge Risk Level 0 (Normal)


• Actions:oStop all intermediate or long term bullish trades

oReview and tighten up stops

oConsider taking off partial profitable positions such as 30% of position if you are up 30% or more.

oReduce position size of new short term bullish swing trades, consider entering half and entering the second half on a pullback with the same stop.

oSell covered calls See covered call enhancement rules for stocks you own

Portfolio covered calls over entire portfolio

oBuy protective puts for stocks you own.

oSell bear call spreads on the weakest index.

oSet up volatility bombs (put calendars).

Hedge Risk Level 1 (Yellow Light)


Actions:• Stop all bullish entries• Start bearish directional trades• May shut down short term bullish trades• Invoke long Delta bearish hedging strategies • Hedge Risk Level 2 potential action steps:o Double check your alerts for key support areas that would

trigger additional actions.o Double check all of your stops; whether hard stops or

alert stops to trigger a judgment call by you. Have your thoughts collected as to what decisions and strategies you might want to invoke. Be prepared.

o Calculate your long delta portfolio exposure. You need to know how much long delta you might want to hedge, and what percentage you might want to hedge.

Hedge Risk Level 2 (Red Light)


• Beta weight in SPY and then look up the 30 day expected move and multiply the SPY beta weight x 30 day expected move x 3 for a 3 standard deviation move. This should give you the extreme expectation.

oConsider lightening the exposure if you are not happy with the amount of exposure given the current risk level.

• Consider closing out any bullish swing positions or at least review each for tightened stops; or to manage profit management more closely.



• Add up all your core put selling positions. If you were to be assigned everything that you have on are you really ready to accept that. Remember at least for those that are modeled here we said that we were willing to own those shares in that position size at that strike.

• Are you really?

• Do you have enough trading capital to actually take possession of all those puts?

• Now is the time to ask those questions and insure you have a plan?



Actions:

• Manage hedges until line turns positive and then start scaling out.

• Manage directional bearish swing trades until market posture turns positive and crosses above 20.

• As situation bottoms can start to but on put credit spreads, back ratios, and sell puts on core portfolio positions.

Hedge Risk Level 3 (Crash Warning)


Actions:

• Consider buying calls or leaps on stocks you want to own.

• Follow Through Day (FTD) – signal to return to bullish trends and to remove any remaining hedges.

oStarting from Day 4, index must be up at least 1.25% to 1.7%. The most powerful follow through usually occur on the 4th to the 7th day of a rally.

• ($VXV/$VIX) closes an entire candle above 1.00 after having previously closed below 1.0

Hedge Risk Level 3 (Crash Warning)


Goals:

• To protect our overall Portfolio over a longer period of time, i.e. 12 months.

• Goal is to be as inexpensive in cost and commission as possible.

• Goal is to be as Theta Friendly to reduce cost.

• Goal is to be as user friendly in set up and easy to manage as possible.

• Goal is to be maintenance free as possible.

Long Term Hedge Strategies – 12 months long


Vehicle - SPX

Expiration - 1 year

If you do not have a 1 year or 365 (or so) expiration, you can do a little math and see where you get more bang for the buck…. shorter or longer. In necessary usually prefer to go out further, rather than closer in.

If you were to come in too much closer, 8-9 months for example, you still have expensive contracts and Theta Decay, but you tend to give up some time coverage.



Vehicle - SPX

Strike

10 Delta puts. If you do not see a Delta 10, go to 11.

This trade set up has a lot of Long Vega and the Vega will cause the position to dramatically increase in profit as well.

Adjust your volatility by 20% to project a typical “crash”

Position sizing – 1 contract per $100,000 portfolio needing a hedge.



Vehicle - SPX

Adjustments

You will lose value to Theta Decay almost daily.

If the SPX continues to go higher you will start to lose some of the pricing benefit.

2 indicators to keep in mind; price and time

Your Indicator # 1 is Price

When you reach the ½ way point to your expected move on the UPSIDE, it’s time to roll it up. Set an alert.

Indicator # 2 is Time

We will “roll” the PUT at 6 months out.

This started as a 12 month trade, so in the 6th month, you should;

Buy a new 12 month PUT for protection and then immediately sell the original SPX put.



• To protect our overall Portfolio over a medium period of time, i.e. 4-6 months.

• Goal is to be as inexpensive in cost and commission as possible.

• Goal is to be as Theta Friendly to reduce cost.

• Goal is to be as user friendly and easy to manage as possible in set up.

• Goal is to be maintenance free as possible.

Intermediate Term Hedge Strategies – 4-5 months long


Vehicle - VIX

• You may not realize that the VIX has slower Decay than most other vehicles.

• The VIX is one of the few instruments that will “over estimate” a move, due to fear. We will use this to our advantage.

• Remember we are not trying to predict the magnitude of any sell off, only relying on the fact that we will get a sudden and sharp move in the VIX.

• In using this strategy, we are not creating blanket “protection” as with the Long Term Trade, but rather setting up the trade to profit from Volatility in a downdraft and thus offset portfolio losses.

• This will be a high risk / reward trade or high “payout” if the market sells off.

•



Vehicle - VIX • Expiration - go out 4 to 5 months.

• Variations in using 4 or 5 months are determined by comparing prices. Basically, if I can get an extra month for .05 or .10, I will go to 5 months.

• Choose your Strikes

• We will be buying an ATM 10 wide CALL Debit Spread vs. buying long CALL’s.

• We will choose our Strikes by simply buying ATM, at the money, and then selling against the ATM with an OTM, out of the money CALL.

• Position sizing – 5 contract per $100,000 portfolio needing a hedge.

• There are two things will happen with the VIX Trade as with the SPX Trade.

• Although lower, you will lose value to Theta Decay almost daily.

• If the VIX continues to go lower you will start to lose some of the pricing benefit.



Vehicle - VIX • Adjustments:

• We will “roll” the Spread at 2 to 2 ½ months out. Set an alert.

• This started as a 5 month trade, so in the 2th month, you should consider;

• Buy a new 4-5 month VIX Spread for protection and then immediately sell the original VIX Spread.



Index Bear Call Spreads

• SPX

• Phase 2 bear market type

• 20 – 60 DTE

• .30 - .40 Delta, then buy 20 points higher

• Exit 4 – 10 days to expiration or sooner at 80% of maximum gain



• Buy index put calendar spreads to hedge mortgage strategy, iron condors, and other option income strategy downside risk.

• Carpet bomb – spread the put calendars around area of risk – single contracts applied to any strike and expiration.

• 30 DTE short and at least 60 DTE long.

• 1 put calendar for every 8 $10 wide put spread.

• Close when short option is a 3 Delta.

• Close 4 – 10 days prior to expiration of the short option and reinitiate a new put calendar.

• Buffer against big down moves to allow you to close put credit spreads or execute other hedge tactics.

Intermediate Term Hedges -Volatility Bombs


• Buy index bearish put butterfly hedge mortgage strategy, iron condors, and other option income strategy downside risk.

• When to put on:

• ~56 DTE and the RUT has moved up at least 40 points without a significant pullback.

• What –o 1st tranche RUT index with center strike ~ 15 – 30 points below

current price.

o 2nd tranche if RUT continues to move up another 20 points

o 3rd tranche if RUT continues to move up another 20 points

o Manage as a combined position rolling the tent as necessary with leap frog

o Exit at 30% profit target based on total capital allocated.

o Works beautifully in combination with SPX bull put mortgage strategy.

Intermediate Term Hedges -Hybrid Volatility Bombs


• This strategy is approximately 1 week to 1 month long and is designed to hedge against an “event” such as FED meeting, NFP, Greek referendum, Interest rate hike, etc.

• To protect our overall Portfolio over a short period of time, i.e. 1 week to 1 month.

• Goal is to offer protection for a known event, or for a very short timeframe.

• This trade will be expensive, so the Goal is to take it off if it goes against us.

• Goal is to be as maintenance free as possible.

• Goal is to use a little theta as possible.

Short Term Hedge Strategies – days to weeks


Vehicle - SPX

Remember we are trying to create “blanket” protection for a very short period of time or an upcoming event.

This will be a little more maintenance as you need to watch your theta and your P/L closely.

Expiration

For this strategy, we will use a standard Calendar Trade, but will “lean” it Bearish. I like to go out 30 days for the front month and 60 days for the back month. This keeps your theta decay as low as possible.

I would consider expirations as close as 25 days on the front month, but this is not a weekly trade so I prefer to go to 30 days if possible on the front month.

I would consider expirations as close as 55 days on the Back month, but again, this is not a weekly trade so I prefer to go to 60 days or longer if possible for the back month.

We will be comparing cost here and using the most cost effective method.



Vehicle – SPX

• Strikes

• We will be buying a bearish calendar so I want to set my strikes to be ½ way to our expected move on the downside.

• We will choose our strikes by simply looking at our expected move and then going at LEAST ½ way lower than the full expected move.

• We use either CALLs or PUTs

• Volume in the Strikes should not be an issue here as the SPX will typically have decent volume.




Vehicle – SPX

• SPX 5 delta put - lottery ticket 1 year out


Speculation Hedge Strategy


Covered calls and short call index spreads can both enhance a portfolio by adding to benchmarked returns.

When: trigger when the market posture turns weak bull, neutral bull, or weak bear.

Enhancement Hedges


• Covered calls against the stock you own.o Spread out the strikes and expirations – ladder

o Consider in the money strikes if willing to be called out.

o Calculate the returns for the strikes.

o Re-entry is only a commission away, don’t be afraid to be called out.

Enhancement Hedges


• Portfolio Covered Call - short call index spreads to cover the portfolio while allowing the individual stocks to grow.

o Identify the part of the portfolio that you wish to “cover”. May only cover a percentage such as 10 - 25% much like you would hedge to the lower side.

o Sell 20 – 50 days out with a 60 – 70% probability of expiring OTM.

Enhancement Hedges


•Process:

•Beta weight and find equity Delta

•Determine amount of enhancement of equity Delta (10 – 30%)

•Select expiration (20 – 50 days)

•Sell 60 – 70% probability of expiring OTM

•Calculate the spreads Delta

•Divide the enhancement amount by the spread’s Delta for number of contracts.

Enhancement Hedges


Puts, futures, VIX calls can be added to provide protection against bearish activities in equities.

Protection Hedges


VIX calls strategy

• Very patient, no stop, will often have to wait months for the spike to occur.

• Average is 2 times a year.

• Set an alert: VIX below 12 is the current trigger.

• Buy ATM VIX calls 3 – 6 months out. Consider seasonality impact for timing when market weakness is likely to return.

• Do not sell calls for a spread (you want to be able to benefit when the spike occurs).

• 7 calls per $100,000 of equity exposure.

• Choose VXX or VIX depending on slope of term structure of VIX futures.

• Can sell the VIX puts at the same strike, or create a back ratio.

• Time exits through market timing. See timing tools referenced below.

• Scale out (about 75% of VIX spikes peak about 18 and most others peak about 21).

• When: added when VIX falls below 12.

Protection Hedges


Long puts strategy

• Purchase a month beyond the period of protection needed.

• Buy a 30 – 40 Delta. Judgment will influence whether to use the upper or lower threshold of the window.

• Position size using notional value:o Total U.S. stock equity/ SPY (or SPX) = number of shares

o Number of shares / 100 = number of contracts.

• Position size using Beta weighting and options:o Beta weight to SPY (or SPX)

o Total the Delta for U.S. stock positions x 0.3 = amount to hedge (30% hedge)

o Choose a strike, or combination of strikes, that provide the Delta protection needed.

o Divide the total Delta amount you want to hedge by the put’s Delta.

o Divide by 100 = the number of contracts

Protection Hedges


Futures hedge strategy

Position size using Beta weighting and futures:• Beta weight to SPY (or QQQ, IWM)

• Hedge 5 – 30% of Delta risk

• Divide by Beta weighted Deltas for the future you are using as the hedge = the number of contracts

o /ES = 500 SPY Deltas

o /NQ = 1,000 QQQ Deltas

o /TF = 1,000 IWM Deltas

• Set stop loss at technical level at which protection is no longer needed and market condition would have settled.

• Set target at technical level of expected support.

• Can use a 3 SD Bollinger band on the $VIX confirmed with price action.

• VXV/VIX ratio with 1.20 and 1.00 trigger levels.

• Scale in and scale out.

Protection Hedges


• Speculation – bearish swing strategy

• Using the same triggers and chart patterns that you use to go long begin layering in some bearish swing positions.

• Use relative weakness to determine the most likely to fall in broad market weakness.

• Understand high beta/ low beta/ defensive/ non-defensive opportunities.

• First to fall – first to bottom and reverse; watch for clues that a reversal is beginning.

Protection Hedges


SPY Puts

For SPY use puts about 17 days out and 2 dollars OTM looking for a 1% move to take into the money.

SDOW

SDOW Stop management - depending on your level of comfort you would set an initial stop-loss of perhaps as tight as 25 cents if worried the market will come roaring back up, OR if you have more conviction that the market will fall lower, you can set a wider stop of 50 cents.

Once the market falls, setting the stop-loss is a personal choice but I prefer to tighten the stop to within 20 to 25 cents once my trade turns profitable. I then wait for the next support level.

Once the support level is achieved tighten stop to 10 cents.

Intraday Hedges


SDOW 6-10-12-20 Strategy

1) The trailing stop-loss I use is 6 cents.

2) The initial stop-loss I use at the entry is 10 cents.

3) The stop-loss is changed to a 12 cent stop-loss whenever the profit reaches 20 cents.

This strategy is designed for bull markets when the Dow is experiencing a pullback or a dip intraday. It is designed only for the SDOW because the underlying index is the Dow and I need the larger swings the Dow often has during a downturn.

The Mechanics

Once I enter the trade, I set the initial stop at 10 cents. Once the SDOW ETF rises I set my trailing stop-loss for 6 cents and then only change it when the profit reaches 20 cents. At 20 cents I then change to a 12 cent stop-loss. This is because I have found that often when the trade is up 20 cents, the Dow is falling harder. By adjusting to a 12 cent stop-loss I often manage to capture far bigger returns than the 6 cents stop-loss can provide.

Intraday Hedges


• Understand the way ultrashorts work.

• DO NOT use for more than a day or so.

• SH – ok to use for intermediate term swings; simple inverse.

• SDOW and other ultras are VERY different.

Ultrashorts – Danger!


• Many high volume ETFs have reverse ETFs available.

• Hedge with “perfect” or like composition whenever possible.

• Currency hedged ETFs for country ETFs; DXJ & DXGE

Alternative Specialty Hedges


SPY put ladder – may be initiated on an intraday basis and then roll into a multi-day strategy.

During correction and bear markets buy SPY puts. You want to make profits each day but also to hold additional SPY put contracts in case larger moves lower lies ahead to profit from. You also want to get the original capital in use back out of the trade as soon as possible.

The first time purchase 100 option contracts. Each day sell half of the position and then on the following purchase add 20 put contracts.

Use ATM with at least 21 days of time.

SPY Put Ladder


• Day 1 Buy 100 contracts and then sell 50 or half at a expected bounce area using intraday market timing.

• On the next pullback buy 70 puts for a total of 120 contracts.

• On the next move lower sell 60 contracts.

• On the next pullback buy 80 contacts for a total of 140 contracts.


• On the next pullback buy 90 contracts for a total of 160 contracts.


• On the next pullback buy 100 contracts for a total of 180 contracts.

• On the next move lower sell 90 contacts.

• On the next pullback buy 110 for a total of 200 contracts.

• On the next move lower sell 100 contract.

SPY Put Ladder


• By doing this rotation you take profits and hold some SPY puts in case of a stronger tumble.

• By rotating the SPY put contracts in this fashion you bring in profits until you are at the point where all the original capital has been returned and you only risking capital that you made in the rotation.

• Requires the ability to make many decisions about intraday market rotation.

SPY Put Ladder


• I am Put Selling against stocks I would own but at or below support levels.• I am reducing the quantity of contracts.• I drastically reduce the number of credit put spread contracts.• I scale into positions as stocks move lower.• I roll down and/or out, positions that end up in the money to continue to

generate income.• I use covered calls at the money and in the money more often but close

them at the first sign of a bounce back.• I use far less margin so that I have margin available for when stocks

bottom or other opportunities present themselves.• I turn to Spy Put Options almost daily.• I trade with a bias to the downside in the Market Direction Portfolio. I

keep a wider stop-loss on the positions that are focused on downward moves such as the SDOW but I use tighter stops on the ETFs for up moves. This is because in a downturn, spikes higher are sharp and swift but can give back a lot of the move up within a matter of half an hour. Downward moves however tend to last longer allowing for a wider stop-loss spread.

• I do more Credit Call Spreads and Naked Calls.• I close positions early to lock in profits.• I focus on those stocks that are declining the least at the present time,

despite the selling.

12 Changes in Strategy When Trading in Down Markets


Downside adjustments for option inventories:• Ratio spread• Expect volatility to rally as the market falls, the short 1 long 2 ratio

spread • Will not expand the trade out• Quickly flatten the curve• Primary adjustment if downside volatility is normal

Put spread• Versatile but somewhat expensive• Secondary adjustment

Margin trade• One by two front spread makes a lot of sense• Inexpensive• Sets very wide tent and can profit when market turns around if set

properly

Calendars and Iron flies• If reach the breakeven point the first adjustment to consider is to close it

and reset later

Key Adjustment Tactics for Downside

Q & A

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