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In the current Platinum Toolbox and Analytical Toolbox series, as well as the retired Personal Finance series, I've written articles that explore different approaches for hedging portfolios. The aim has been towards achieving a reasonable hedge for a group of stocks and/or exchange traded funds without having to purchase puts for each individual security. This reduces costs by reducing commissions, but more importantly by reducing slippage. In addition to reducing the number of transactions impacting slippage costs, it's possible the spread size is also reduced when using more liquid contracts.

I recently updated a hedge discussed in the November Platinum Toolbox. It was updated on the discussion boards, and needless to say, the two-week market performance has lead to lackluster results for the hedged portfolios. Bull markets definitely force a trader to use a hedge approach that makes sense from a cost standpoint. In all cases, an effective hedge remains paramount.

As with other aspects of trading, there's generally something you have to give up when reducing costs in this manner. The portfolio hedge will likely be less effective than hedging each security individually. In addition, investors may want to consider the security's historical volatilities to determine if a hedge makes more sense than a basic stop. Given the variables to consider, the trader should map out in advance an approach that is best for them. It's possible a combination of the two is the sweet spot for the individual.

Regardless of the method chosen for hedges-portfolio or individual security-the trader should expect to see portfolio returns dampened, particularly during a bullish market or when put protection is purchased in a high premium environment. With this in mind, it's reasonable to expect a trader to lose their risk management resolve during extended bullish periods. By incorporating specific mechanical steps and keeping hedging costs down, the trader can ideally manage risk in a manner that suits his/her individual style. As a last step, adding objective market timing signals may enhance the process by allowing the market to dictate the extent to which positions are hedged.

Between now and the end of the year I am going to revisit and assess the different investment oriented methods discussed over the last few years to include:

• Correlation considerations;
• Hedge approaches & results; and
• Portfolio tilts.

If there is time, a look at different relative strength approaches will be added to the portfolio tilt results.

Portfolios

The traditional investor approach to managing portfolio risk is asset allocation in an attempt to diversify non-market risk. Option traders have additional risk management tools at their disposal, including protective puts and collars. By comparing different methods for risk management with options, investors can test those that best suit their style and identify potential improvements to them so that risk is managed while the impact of the added cost is minimized.

A first step in assessing portfolio risk is to calculate the correlations of returns for the securities within the portfolio. This will be completed using different holding periods including daily, weekly and monthly (third Friday), as well as correlation characteristics given different market conditions. These conditions will be defined using objective tools.

Security Hedge versus Portfolio Hedge

In this series, the hedge decision includes:

• Which securities in a portfolio to hedge;
• Whether or not the security will be hedged using proxy options;
• Whether a partial or full hedge will be implemented;
• Which month and strike price are appropriate for the hedge;
• How frequently to assess/adjust the hedge; and
• What place, if any, market timing has in the hedge decision.

In addition to correlation, a security's volatility plays a role in whether or not it requires a hedge and how to approach it.

Correlations provide investors with information about past movement, but to what extent should the investor expect these relationships to hold up going forward? Does a strong correlation today necessarily suggest a strong correlation will be maintained? A look at the predictive nature of current correlations will be assessed since it's an important assumption used when hedging individual securities with a proxy security.

Market Timing

One of the most straight forward approaches I've found for objectively assessing market conditions is through the use of Moving Averages (MAs). I generally use relative placement of different period MAs to identify short-term, intermediate-term and long-term conditions, however; relative price placement can also be considered. I'll be exploring both in the next few weeks to see if a reasonable filter can be added to the hedge decision. For instance, does portfolio performance over the long-term improve if hedges are only implemented when the 50-day MA is below the 200-day MA?

Mapping out the different issues makes for a more vanilla article than any type of back-test results, but it's a necessary step for obtaining meaningful results. It is possible one or more of these factors will be too data intensive to provide an apples-to-apples comparison for different approaches, but nothing ventured nothing gained. The main goal is to provide food for thought as you assess your risk management techniques as you continual to build approaches that suit your style.

Clare White, CMT
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site

Questions for Clare? Please visit the discussion board on the homepage of Optionetics.com.

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