I dunno but it looks very scary to me...
I dunno but it looks very scary to me...
Two things to consider: 1) what does the graph really tell you, and 2) how to deal with large opening gap-downs.
The graph above shows three major gap-downs and the time spans between those. The human mind is very good at extrapolating such data and draw the conclusion that a next episode must be near. But is that really the case? First, the interim periods show no consistency. Second, there is no data shown prior to 1987. Third, and most importantly, what would be the rationale for having a major gap-down at certain periodicity? In other words, I think this graph is suggesting something that is not there. We can discuss the specifics for all three events shown and agree that those conditions are not present currently.
Having said that, there is always the possibility for a major event resulting in a gap-down opening. Thus, it is prudent to be aware of this and have a plan for dealing with it. This could involve always having black swan protection in place (proactive) or an action plan during such an event (reactive). That would be a useful discussion to have.
Is it possible to gap down over 5% now with the market circuit breakers?
I think it must be possible since there was a < -5% opening gap that occurred in August, 2015. Looks like the 5% rule only applies to after-hours trading.
"On the New York Stock Exchange (NYSE), one type of trading curb is referred to as a "circuit breaker". These limits were put in place after Black Monday in 1987 in order to reduce market volatility and massive panic sell-offs, giving traders time to reconsider their transactions. The most recently updated amendment of rule 80B went into effect on April 8, 2013, and has three tiers of thresholds that have different protocols for halting trading and closing the markets."
"At the start of each day, the NYSE sets three circuit breaker levels at levels of 7% (Level 1), 13% (Level 2) and 20% (Level 3). These thresholds are the percentage drops in value that the S&P 500 Index would have to suffer in order for a trading halt to occur. Base price levels for which these thresholds will be applied are calculated daily based on the preceding trading day’s closing value of the S&P 500. Depending on the point drop that happens and the time of day when it happens, different actions occur automatically: Level 1 and Level 2 declines result in a 15-minute trading halt unless they occur after 3:25pm, when no trading halts apply. A Level 3 decline results in trading being suspended for the remainder of the day."
"Circuit breakers are also in effect on the Chicago Mercantile Exchange (CME) and all subsidiary exchanges where the same thresholds that the NYSE has are applied to equity index futures trading. However, there is a CME specific price limit that prevents 5% increases and decreases in price during after hours trading."
I wouldn't expect them to, otherwise option prices would reflect it or there would be an arbitrage opportunity.
SPY only began trading in 1993. I tried to analyze YAHOO! data for the SPX, but the data has different properties. It didn't reflect the ~9% opening gap-down moves that traders experienced in 1987, 2001 and 2008. Does anyone know why that would be the case?
How so? No predictions are made. It only reflects what actually happened. Color-coding was used to highlight the disparity in the frequency of events between -2% and -3% and those < -3%. Days where the markets gaps-down < -3% are far more rare. The effect is highly non-linear. In fact, it only happened 11 times since 1993. The vertical bands do suggest a clustering effect for market shocks, but that's well-known. I added them because they hint that opening gaps < -2% may sometimes be 'warning shots', which is a very useful concept, IMHO.
There is a good case for employing Occam's Razor (law of parsimony) here, I think. The graph (and history) SIMPLY shows that bad things happen in the market occasionally, but without any discernible periodicity. In other words, we over-complicate the markets by reading too much into historical data. Can the "end of days" come? Of course, but remember that in the event of a nuclear holocaust money will have no value. Yet, we don't routinely concern ourselves with that possibility. So, personally speaking, I am vigilant but do not have an apocalyptic mindset. I periodically see pamphlets in the Starbucks rest room dealing with the Beast, 666, and quotes from Revelations. But, we are still here. My mindset has always been (check with my former students at SOM): "trade the trade and be ready for big down days".
I'm sorry if I misinterpreted your original posting. Given the title of the thread, I assumed you were implying a major down occurrence is pending. I just tried to indicate that such a conclusion can not be drawn from the graph. I fully agree with Dan's view above.
Perhaps we are headed to one. Seems that human emotions might be controlled by something outside of what we think is all that logical. Apparently there has been research on major battles in the world. Every few years the world goes nuts and people go to war. Some call point to the Shmita year and other point to the 8 year cycle. Then there is the Jubilee year.
I used to think we are logical but unfortunately we are can be stimulated and affected just the same. This is not a stock market graph but I am leaving this here for folks to ponder upon. I have always wondered why governments spend so much money on this.
There is not a large enough data set to make any sort of statistical conclusion except what we already know which is that financial markets have fat tails.
Agreed. We can't make a reasonable prediction of the waiting time until the next ~9%+ black swan due to the limited sample size, but I don't think that means we shouldn't be discussing black swan risk management methodologies. At this moment, based on the three data points mentioned, I think it's prudent to assume these events have at most 14 years between them, even if that's not true.
Many traders on CD seem to have at least 25% of their accounts dedicated to strategies that can withstand a 5% downside move, possibly with some sort of manageable loss. What does that loss look like at ~9%+ though? How much of your account size would you lose if, sometime in the next 5.5 years, you woke up to a market that's gapped-down 10% on some completely unforeseen geopolitical event?
What are people in this community doing today, if anything, to ready themselves for something like that? The purpose of this thread is to motivate that discussion.
So-called "teenies" (i.e. cheap low delta puts) are actually a reasonable hedge at least for BWBs like the RTT. Even if it's not a complete hedge it would still have the effect of significantly cutting your max loss in a crash. Conditional orders to buy a put can do the same thing but what if the market gaps past the trigger price?
This. I feel you already need to be net-long puts when the proverbial fan gets hit - it's too late when the market is free-falling. Puts will be very expensive then. One of the things Tom Sosnoff and I agree on.
What's your opinion on 'teenies' vs. backratios?
I don't know about backratios but I seem to recall discussion about a "sea of death" when using put backspreads.
I'd stick with teenies as crash insurance.
I know Ron Bertino is a proponent, but in my simulations, I have yet to construct a backratio that offers any meaningful additional benefits over corresponding 'teenies' other than a slightly-higher downside B/E at expiry and a slightly-lower initial debit. Has anyone been able to take advantage of skew when constructing backratios? I welcome any comments on things I might be missing.
There's no getting away from the fact that back ratios mean buying (very expensive) skew ... the only slight skew benefit is that being long the two means you can sell one teeny against it, if the back ratio is close in enough (that is, net you are selling a BWB with a very wide lower leg) ... doing this, you cap the left side of the t+0 but you can cap it at a positive terminal value.
IMO back ratios are best constructed near strikes where your fly lower leg is, roughly and plus or minus ... in this area they can be significantly less expensive than equivalent long option protection, but they need to be managed (rolled, contracted) to avoid issues of sea of death and getting-too-expensive-to-hold. Most traders don't like this idea because effective hedging is very expensive ... you can't just blow a few hundred on unit puts and/or VIX calls and expect to have a good hedge for a 10% gap (30% yes, 10% no) ... rather, you have to get serious and say, for example, "I'm going to blow a full 33% of my expected trade profit on a hedge that will reduce my max loss by 66%, raise my far left p&l to about $0, and make my near t+0 line quite a bit better, but still very painful on a big gap down."
If you prefer to live the lifestyle of always being hedged for the big one, check out Bertino's group ... the ideas are (1) have your income structures far down enough so the hedges necessary to protect them are effective in spite of being very far OTM, and (2) as a way of life, always be blowing a chunk of your potential profits on building up your hedge portfolio ("blowing a chunk of your potential profits" is what Ron calls "getting free hedges"). It's quite impressive to see the hedge portfolios these guys are building up without spending much upfront.
When I get bored and tired, I look at this https://en.wikipedia.org/wiki/List_of_largest_daily_changes_in_the_S&P_500_Index. It helps to keep me up at nights.
Not necessarily true. Following is chart (from the book "Second leg down") selling 1x2 put ratio on delta neutral basis weekly gross of costs. Average premium cost is 6 bp/week or about 3.1% per year.
Edit: just to clarify nomenclature of the structure for any new visitors of the site. Author says short put ratio, which is same as buying backspread as you mentioned. Short near the money, buy more wings OTM
That is a suspicious looking chart for a long-vol profile trade. Where is the short strike placed? How many DTE? Does "delta neutral basis weekly gross of costs" mean that you put in on delta neutral, then close out/reposition one week later?
Time for a large-scale automated back test! Can you provide the precise parameters of the trade?
Sure. Quote from his book "We have tracked the performance of a short 1x2 put ratio on the SP500 over a 10 year window. Specifically, we sold 1 25 delta put and bought 2 10 delta puts, resetting the structure weekly. Both strikes had 4 weeks to maturity at initiation. Our results are summarized in Figure 4.9"
Ok so it's a long delta trade - that totally changes the picture since simply being long deltas is a great strategy over long time periods. Does he provide long-term results for the 2x5?
Steve. Unfortunately no.
I initially disagreed with your post in the following area.
He has graph after adjusting for in-sample volatility 10 deltas puts are cheapest compared to near the money or 25 delta puts, so that is better suited for hedging. Also you see in the above charts effective hedging is not very expensive (3.1% per year)
There were few 5 to 10% gap down during the testing period. 1x2s seems to have performed better
Thank you to whoever recommended the book mentioned above. I find it excellent and am actively testing strategies he discusses in the book. I have already been using call backspreads in the vol products for quite some time with good success. By good success I mean they have allowed me to profit from my short vol side, not that I have made money on the back spreads themselves yet
I have no disagreements with anything you are saying as I have not done sufficient back testing yet ... my main angle with back ratios is to construct the hedge you really want in terms of (A) decreasing max loss and (B) zeroing out the catastrophic risk without buying more downside than you need ... then see how much this hedge costs and what, if anything, to do about the cost. If your hedge costs you one-third of expected profits on average but it means you can double your trade size with lower net risk, it makes some kind of sense.
I do think it's a rule with back ratios that going too far in strike width is toxic ...
For what it's worth, here's a wide-angle snapshot of a back test of 2x4 SPX back ratio with upper strike at various deltas, entered 55 DTE, 30 DIT, strike width 50 points, dynamically hedged, and rolled whenever the market moves 1%. The p&l numbers are in SPX points. A total of 301,712 trades are represented:
Yes, although he talks about 25 delta and 10 delta I find at least so far in my analysis that keeping the width to 50 points is advisable, wider is as you say "toxic"
And let's not forget Ron's 3x5, he thinks that is a better structure so I'm testing that variant as well
But Ron's trade is long DTE, far OTM and not designed to effectively hedge atm structures ... I'm not sure he has strong opinions on how good (or not) a shorter-DTE, nearer-the-money version is. For what it's worth, here is the same back test pictured above (2x4s, blue) with the same thing on the right except 3x5s (yellow). I look at the 3x5 as a 2x4 with layered-on credit spread ... you give up some of the nearer-strike hedging power to get a cheaper hedge. I also view the 2x4 versus 3x5 fluidly: buy back the credit spread if you're nervous or need a few negative deltas; sell it if you're complacent or need some positive deltas.
Yes, I like the way you look at the structure peeling it into it's layers, I assume you've read Cottle, Saliba etc.
I would tend to agree with you that he is too far out in time, but he has convinced me that it may have merit so I'm looking at it as well. I use call back spreads in VIX also, I think the book gets into those as well but I've only read about the first half or so, just got it two nights ago
First, thanks to Ice101781 for opening up the thread. Great discussion.
Also thanks to Srini for mentioning Hari Krishnan's book. I've been alternating between reading through the kindle edition and running a few spot check back-tests on how the put-ratio performs in a few different environments.
To Krishnan's credit he is very easy to read, and I like that he takes the time to point out the practicalities of the approach, for example:
I also like that he has actually used it in practice:
The short 1×2 put ratio is something that has been in our arsenal for quite some time. It worked particularly well during the Flash Crash of May 2010, when the put skew steepened dramatically for equity indices and risky currencies.Having said that, a close reading of one of the book reviewers, shows the alternative view....position sizing:
Praise for The Second Leg Down
"The most difficult portfolio management decisions come after an unexpectedly large loss in an unsettled market. This book tackles that situation with a comprehensive, accurate and clear account of clever strategies to navigate the troubled waters with little or no sacrifice of upside. It's well-written and entertaining. Most of the time you're better off with the unclever idea of cutting positions to where you're comfortable for the risk, but if you refuse to do that, this book gives you the best chance of profiting from your aggressiveness."
—Aaron Brown, Chief Risk Officer, AQR Capital Management
Yes. Thanks to the OP for posting the topic.
Since i carry futures position overnight, I am always worried about sudden reversals. Being long equities, short bonds and risk currencies is worst possible scenario, when s@#t hits the fan overnight. Correlations break down during that time. One may not have time to cutting the positions as Aaron Brown says.
Also most of AQR runs their funds at risk target of 10 or lower. Even unlevered SPY has more risk than their funds. It is very easy to shed positions at such low risk target. AT elite trader "globalarbtrader" runs his account at 25 risk target. I would say most of the retail traders is in that range.
To be fair, 1x2's is been their long time and used by many. But i was impressed array in which he employs. Along with 1x2 put spreads, 1x2 in call spreads in bonds and short future VIX+Vix calls. I have done in short VIX puts+VIX call spreads before. Short VIX future+VIX calls is much better strategy. Employing all these together is much better suited for me, since correlation breakdown does not effect having all 1x2 equities, bonds, vix together.
Also I was never much big fan of weekly options. Now his saying of "Vega before, Gamma after" is ingrained in me to just take a fresh look at weekly options.
Reading this thread really underscores for me how little I know about long term hedging, how much I'm exposed to a major move down, and how far I have to go just to understand this discussion.
Thanks for the book recommendation and I'll try to understand the 1x2 and strategies discussed here better. Not knowing what I don't know is dangerous, but at least now I know what I don't know...
A very good point....overnight gaps are the enemy of an optimized fixed fractional or even half-kelly money management system.
It's an awkward point, but I do believe there is gravitational pull once a trader starts expecting much beyond 15% net compounded annual growth rates, as discussed here:
There is no evidence suggesting you can obtain higher than 30% returns year after year for decades on end. In fact, only very few cases throughout history have been able to achieve this at the professional level. And not even the almighty Buffet.source: http://www.the-lazy-trader.com/2017/04/how-has-your-trading-style-changed.html
The Barclay's Discretionary Traders Index is averaging 7.37%/year after three decades. https://www.barclayhedge.com/research/indices/cta/sub/discret.html (with some survivor-ship bias, as funds that under-perform and die stop being tracked).
What we do know, is that 90-95% of traders lose money, and that anywhere from 75%-90% of professional money managers fail to beat the S&P500 on any given year. This means that a +10% avg annual return in the long run puts you at an elite level, as you make money (therefore beating 90-95% of traders), and you beat the S&P500 (beating the vast majority of professionals). +15% is great. Anything above 20% is awesome. Its the cold, hard truth that those who know better, don't want to talk about.
This is a very sensible and realistic view of what investing and speculation can yield in the long term. Way back in 1993, Lawrence Harris had published a paper explaining why most market participants must lose money in order to keep the markets going.
These guys https://www.poweropt.com/ourcompany.asp promote and advocate some fairly realistic and achievable strategies. They wrote a book about it. https://www.amazon.com/Protective-Options-Strategies-Married-Spreads/dp/1592803423 is conservative and prudent though not very exciting.
Just a FYI. If I am not mistaken, I think Ron's 3x5 is a long (debit) ratio spread, not a short (credit) ratio spread or square root spread illustrated in the book.
I maybe misinterpreting. I have a suspicion that you interpreted "risk target" as "return target". My apologies if it is not the case.
To clarify for "risk target", it is nothing but "volatility target". Most of hedge funds (at least good ones) and risk parity strategy (mentioned and warned in the book) invest based on risk allocation, not fixed dollar allocation. Measurements of portfolio allocations by dollars could be highly misleading. Traditional 60-40 (stocks & bonds) sounds balanced, but has 90-10 risk!.
Risk parity strategy achieves diversification, by leveraging lower vol. assets (in this case bonds) to bring it to same level volatility as equities. This is based on historical performance and correlation. What if volatility and performance breaks down after 35 year rate drift down? To control this they target certain volatility levels. AQR targets volatility of 10. This means when ever realized volatility of the individual asset of past certain days exceed 10, they bring down the weights of the asset so that volatility will be equal to 10.
Historically these strategies have done well. One because of bonds had terrific performances with low vol. Second because equities position was significantly reduced just prior to black swan events. If you go back and check, realized vol doubled just before 1987 crash. That means equities allocation would have been halved.
Here good links regarding this.
In fact, I would read anything put out by AQR.
Apologies accepted....thanks for the awesome AQR links...most appreciated.
After reading this book: http://qoppac.blogspot.co.nz/p/systematic-trading-book.html my eyes were opened to a lot of volatility targeting approaches and implications.
You might already have Rob Carver's book.....I was going to post a few scans from it, but I'm not sure how UK copyright laws work
He was running AHL's systematic bond fund back in 2008....a really interesting read (at one point they had a $1B up day in Sept 2008...freaky stuff!!)
One quote from his book about systematic trading won't hurt though:
"....be nervous. Only commit trading capital you can afford to lose. use Half-Kelly: your maximum percentage volatility target should be half what you pessimistically expect your Sharpe ratio to be. At some point some instruments or trading rules in your portfolio will go badly wrong."His blog is really interesting if anyone wants to dive into lots and lots of content, in particular his recent QuantCon presentation (all 52 slides of it )... http://qoppac.blogspot.co.nz/2017/05/some-reflections-on-quantcon-2017.html
Yes. I do have his book and incorporated some ideas into my futures portfolio.
On the general topic of volatility, etc....
I found this recent article https://www.bloomberg.com/news/arti...ddon-theory-warns-of-risk-parity-correlations an interesting read (this opening sentence amused me!):
How will the world end? Not in quakes of discord, but with an excess of harmony.
That’s the new take on how the quantitative strategy called risk parity will collapse the financial system, as its multitude of bets start moving as one. Apocalyptic predictions tied to the investment programs are popular -- billionaire hedge fund manager Paul Tudor Jones warned they’ll be “the hammer on the downside” when markets are laid low.
Briefly: risk-parity funds operate simultaneously in a bunch of different asset classes, weighting their stakes in each according to volatility. If one category of holdings swings around a lot, like stocks, it gets a smaller slice, while quieter bonds get a bigger one. Diversification like this is supposed to balance influences.
Theories have abounded for years that because volatility itself is a sell signal for the levered investment vehicles, sudden bouts of price turbulence pose a latent risk that will one day ignite torrents of selling and melt markets. To date, there’s been plenty of turbulence, but not so many meltdowns.
One has to distinguish between Black Swan event with general sell off. Generally disagree with the premise of the article.
I guess world end qualifies as a black swan event. I don't envision any scenario during black swan event, where in risk-on assets like stocks strongly correlated with risk-off assets like Govt. bonds and VIX.
Even though there are some similarity between portfolio insurance and risk parity strategies, they are completely different animal. In portfolio insurance, it was selling futures to delta hedge instantaneously same asset, where as in risk parity it is buying and selling different assets and it is very slow process. Also all risk parity funds are not created equal. Some look at 1 year and some 1 month correlations. Some are vol targeted and even with in that different funds have different volatility control parameters. (for eg. globalarbtrader floors the vol's to bottom 5th percentile. One can also floor the correlations).
Stock and bonds could do move in same direction, but it does over a time period. Easily risk parity can adjust to those movements.
A bit of a late follow up by me, but here's a quote that agrees with Srini, but has a look at risk parity from another perspective:
"Paul Jones’ risk parity crash thesis is based on the idea that, because the positions are volatility weighted, risk parity managers buy more in times of low volatility (which almost always coincides with a rising market), and then are forced to sell when volatility increases (which usually accompanies a decline). It sounds suspiciously like the dreaded portfolio insurance strategy that contributed to the ‘87 crash (which Jones accurately forecasted and secured his place in the hedgie hall of fame).The rest of the article is here: http://themacrotourist.com/macro/axe-would-hate-risk-parity
OK, here goes my argument on why Jones might be wrong, not about risk parity causing a market dislocation, but instead the market in which risk parity will cause problems.
Risk parity was created in 1996. Since then, interest rates have only gone one way - down."
This is a good topic. I have some thoughts on BS and hedges. I know some people will likely disagree but I'll share anyway....
1. I think by nature of black swan, it's unpredictable, timing wise and cause wise. There is no point trying to predict when it'll happen next and due to what reasons it'll happen.
2. BS should be defined by a sudden, huge crash. 9% daily drop or more does qualify. But not the normal pull back. Not those 3% daily drop or 10% drop over 10 days, ie pull backs like Aug 2015 don't count. Reason is those drops are manageable. We may end up with max loss. But that's okay. Max loss should be part of our trade plans. It will happen and we should let it happen. If one does not expect max loss to happen, then I would say that's a dangerous assumption.
3. There are many ways to hedge BS, but every one of those hedges cost money. Zero-cost hedges DO NOT exist, regardless what some people want us to believe. Think about it - if cost-less hedge exists, billions of dollars will be plowed into it, immediately making it ineffective again. In my opinion, the effectiveness of any hedge must be calculated relative to the cost of the hedge. Creating a hedge and then paying for it with another credit spread does not count as cost-less hedge because the credit spreads do incur risks. If timed wrongly, those credit spreads will lose many more times the cost it's supposed to save. Neither does time layering hedges count as cost-less hedge, ie using an existing hedge to protect the credit spread that is supposed to pay for another hedge.
On average, let's say the cost of BS hedge is about 1% per month (which is NOT easy to achieve), eg. buying VIX calls, or Put back spread, etc.. that's 12% per year. If BS happens in 8.3 years, the cumulative cost of hedge will be 100% of capital. That means, if BS happens once every 8.3 years, the cost of hedge will be equivalent to being 100% wiped out.
So... my personal take - I don't hedge BS. But I make sure my income option capital is an affordable fraction of my total capital. If I do get hit by a BS, I can replenish and resume. In my back testing and actual experience, the expected return of income strategy minus the cost of BS hedge far outweighs the risk of loss due to BS.
If at any point, I worry about BS, then it means I'm trading too big. I'll reduce capital. Having said that, although I don't worry much about BS, I do spend time thinking more about the 3%-4% drop, ie 70pts to 100% drop in SPX in a single day. Those are many more times more likely to happen than BS. However, there are many things we can do to prevent a total destruction of our portfolio. I think spending efforts in learning to manage our positions and minimizing loss in these scenarios is far more important. Just a thought .....
Nicely put, Kevin.
I was just reading the "Fat Pitch" blog today, where the author brought up a relevant point on the frequency of "non black swan" movements:
Hi. It is good topic indeed, and it probably sits in heads of many, many traders all the time. Some thoughts from me; not as a disagreement to what you said, but rather as other approach.
But: not being an expert I read, some years ago, papers about efforts to predict black swan events. Method was based on some structural studies from engineering. Study was looking for some invisible to naked eye cracks and using statistics tried to estimate probabilities of failure (not TA, at least not popular TA). Don't remember details but I know that some work has being done here. One can argue that if crash can be somehow predicted (even only as prob.) it is not BS anymore - it is semantics only, imo - academic for us, retail traders.
I'd argue that it is a matter of individual trader's philosophy. Every investment carries a risk. When risk is minuscule we tend to say that investment is 'riskless'. In reality there is no such a thing as risk-less investment. Even holding cash in account is not without risk, it is very small risk (?) that changes with time and usually is ignored on daily basis, but is not zero.
Similar applys to our investments. What you said may be (may be not) true for around ATM trades, and is likely not true for traders far, far OTM. When your risk sits 20 - 30+% below the market will you include max loss in your plans and spend $ for protection? Heck no! Risk is not zero, but if such a thing happens you will more likely have other things to worry about than state of your account. I'm not saying that such a scenario should be ignored at all, but hedges need to be placed outside your brokerage account. You likely put hedges for 5 -10 - 15% drops, not for max loss.
Absolutely right. So called 'free hedges' are psychological twists than anything else. I'd say that thinking of hedge cost it is not single number that is important like 1%, but rather ratio hedge cost to profits. 1% is 1/2 of your gain if you yield 2%/month, and 2% hedge is 1/5 if you get 10%. (I know it is unreal example, but was given to emphasize concept). With this approach 100% capital cost from your example is less relevant. State of your account after 10 years matters.
That is a one way of hedging used more likely, I think, by us, closer to ATM traders as it is safer and cheaper than position hedging. It is also not free.
So, hedge or not hedge? And how? It depends of your psychology (very slippery), your knowledge/confidence/experience, your trading strategy - it very discretionary. That for us, small traders. We can use systematic approach... and it will eat up our profits and then capital.
I think trading is not for paranoiacs...
I do hedge for BS, especially now. I don't know what will happen. I watch Put Skew slope.
Nice graphic @KiwiDon. It would seem to suggest, at the very least, that there's opportunity to take profits and rebalance bearish-leaning trades even in persistent bull markets. Taking the data a step further, it might be informative to know the lengths of time over which each of those pullbacks occurred. For example, it looks like the -12% decline in 2015 probably corresponds to the August China Panic, which saw the bulk of its move transpire over the course of a week or so; however, locally, it was a part of a bigger downtrend that began slowly around the middle of July and continued through early September.
I agree with the above article generally.
In the context of BS (and in the context of this thread), rates going down from past 30 years or level of rates does not matter assuming we are talking equity black swan here. In the event of BS, bond prices shoot up. Since risk parity is a levered bond position, it will perform much better.
Author point about rising rates causing dislocations for risk parity funds is correct, but it is not black swan scenario. Rates rise slowly generally, in which case risk parity can adjust.
What would be the BS scenario for bonds (rates to shoot up immediately)?. Only case i can think of this scenario is possible is when "supply shock" happens ala oil embargo. In that case inflation shoots up, bond prices collapse and rates rises. Demand shocks (for ex 2008) are benign to bonds.
I am not sure you are assuming 1% of entire investor portfolio or just trading position.
We have to think entire portfolio (both investing and trading) as one. If your 1% number is just for trading portfolio and this hedge hedges both trading and investing, then it makes sense. We have to assume some general number to put this in context.
http://www.cboe.com/framed/pdfframed?content=/micro/buywrite/assetconsultinggrouptailriskmarch7final.pdf§ion=SECT_MINI_SITE&title=Key Tools for Hedging and Tail Risk Management
This paper assumes one buys 1% of VIX calls on trading position. Assuming 20% is your trading capital and rest is traditional portfolio, hedge cost is 0.2% per month or 2.4% per year. This is pretty close to 1x2 put spread cost (3%/year) shown in the book. This cost hedges entire trading and investing portfolio. Since this also reduces portfolio volatility and if trading portfolio has a positive expected return then efficient frontier of entire portfolio is much better. You can see that in the above paper also
Replenishing your trading portfolio after BS is not that clear cut or easy. From your example, you wipe out 20% of portfolio, and loose another 5% (assuming balanced portfolio) or so from 9% drop. That is pretty close to 25% loss of entire portfolio. Not many will replenish another 20% to trading position next day.
JP morgan does put out nice insight every quarter.
I am assuming hedging actual deployed risk for options only. Does not include other portfolio. I would love to be able to achieve a hedge cost of 0.2% per month with VIX calls. That's fantastic. Can you show an example of how that can be done ?
Some historical data that might be of interest to some of you. This table shows all the dates since 1990 when SPX dropped more than 4% in a single day (that's approx 100 pts drop today). A couple observations :
1. Majority of the big drops happened during the 2008/2009 financial crisis. The rest happened mostly during the 2011 period. If I remember correctly that's the first Greek financial crisis. Other than these turbulent periods, the number of days with >4% drop is extremely rare.
2. Every one of these big-drop days happened when IV was already elevated. Hence, as we plan our hedges, we mustn't rely on a gigantic vega pop to save the day. As shown in the table, there were some IV pop but none of the big drops happened when VIX was in the low teens and then suddenly shooting up to 40s and 50s. Yes, if we are lucky, we could enter the hedge when IV is low but history doesn't support that scenario. More likely than not, we'll enter the hedge when market turbulence has already started and IV is already moderately high. Therefore, when we calculate the cost of hedge, we must take that into consideration.
I have dug up some old slides of Larry McMillan's seminar on risk management. They concisely highlight the fundamentals of risk management techniques which small retail traders can apply. The recommended reading list in the slides are also good. https://goo.gl/Y93BXJ
Edward Thorp is a reputable mathematical gambler/speculator/investor. (Many years ago, I learned to profitably trade convertible bonds and stock warrants from his teaching.) He publishes his articles here http://www.edwardothorp.com/articles/ .
I took literally from CBOE's paper. VIX tail hedge strategy published in CBOE assumes purchase of VIX calls using 1% of portfolio and rest in SPY and rolls every month. Since we are assuming 20% of trading position and rest in traditional portfolio, 1% of trading capital is 0.2% (1% of 20%) of entire portfolio per month or 2.4% per year.
For 1x2 position, I have posted the picture and 3% per year hedging cost published in the book "Second leg down" in the page 1 of this thread.
I noticed that Larry McMillan also uses "Hedge 20% of NAV" using VIX calls in his presentation.
I volunteer to be your assistant editor. This is the link to the specification of VXTH, http://www.cboe.com/products/vix-in...egy-benchmarks/cboe-vix-tail-hedge-index-vxth
I am pretty sure that Larry was referring to the same CBOE studies that you posted. But he emphasized 20% of EFP (exchange for physical) transaction value of the portfolio. https://www.cmegroup.com/trading/equity-index/exchange-for-physical-efp-transactions.html
Wasn't Summer 2011 the US debt rating downgrade from AAA to AA?
Kevin, the table you posted got me thinking as I was making myself breakfast today. Why not view the moves as quantities normalized in terms of the number of previous day's implied vols they represent?
Granted, the sample size is tiny (and the R-squared could be higher), but I do think the negative relationship is meaningful. To me, it's direct evidence that OTM fly's, etc. actually become less susceptible to overnight risk as fear grows in the market, which is counter-intuitive. In the above graphic, the last two highlighted rows on the left illustrate the concept pretty well. Same percentage drop, same absolute drop, different VIX level - which means the -4.20% move had much more destructive potential in '02 than it did in '08.
Additionally, the practical takeaway is that the data appear to suggest holding structures that allow for a 5-6 sigma overnight event - simply thinking in terms of percentage moves when hedging creates apples-to-oranges comparisons.
This is a good chart. It does show an important point - it's not the absolute movement that matters but rather how much were you paid when you entered the position vs actual market movement that's important.
For anyone who's interested, I wrote a blog post as a follow-up to this topic which can be found at https://retailquant.blogspot.com/2017/07/seeking-trade-balance-in-context-of.html.
For now, I am with you.
I lost more on using Backspreads as hedges versus simply buying near the money, very short-term SPY Long Puts.
The Backspreads often "dip" well ahead of the sea of death area, and that is where I get stung...even if I put on/take off in a week or so's time. This could be a function of a constantly rising market, as the IV keeps dropping. The SPY close-in Long Put gives you a much bigger profit, close to the money, whereas the Backspread doesn't.
Yes, the Long Put scheme costs you more.
Perhaps when the market starts changing direction, a Put Diagonalized Ratio Spread would be best. But, for now, the Teeny seems like the simple and effective way to go.
These days, it makes sense to me to focus on short-DTE downside protection when hedging my longer-term income structures. First, it minimizes initial costs. Second, OTM puts cling to premium near expiration. Third, by that point term-structure decay has likely steepened the skew from where it was further out in time, so there's relative value on OTM put debit spreads. Fourth, these types of debit spreads will be much more sensitive to changes in the VIX than will the later-dated income trades - which means higher-powered Vega and Vomma.
The guy who sold it to you might be an income trader - that dip is his profit hill. The skew favors sellers of backspreads.
Yeah, maybe in a high-vol environment - would be interesting to research.
I hear you.
Just out of curiosity: are you running your hedges in systematic way or is it more discretionary thing.
Ice, if you don't mind me answering this one (too)...
Marcas, what I do is very simple: I go to the Analyze tab in ToS, bring up the Portfolio view, toggle on/off different SPY short-term DTE, close to the money Long Puts, both with/without the Put Skew IV value change (Vol Step +4 set to 10), and see what level hedging and Long Put cost I am happy with, then place the trade. The IV Skew can be found at the bottom of the Trade tab, called "Product Depth".
Take careful note of the SPY Put pricing the further out in time you go. It is not linear; you do NOT get the better price/day going further out in time. You'll see jumps in cost. Play with it; you will see what I mean.
This simple, cheap hedging with these Long Put weeklies is very effective on my end, I think because I don't have my structures on top of/near ATM. Depending on my DTE initiation of a structure (I time layer), a structure's T0 doesn't go to BE until 5% - 25% down or so. Therefore, cheapo SPY Long Puts have a long take off distance before their hedging is needed. Of course, the added positive Vega is a nice touch.
I like the idea of systematic hedging. My current income campaign (Dec) was initiated alongside an A:B:C ratio of VIX calls across the term structure (Oct, Nov, Dec). I'm finding that even at these rock-bottom levels, the cost-of-carry (contango loss) is still just too high and it's been a real drag. In the next cycle (Jan), I plan to use an estimate of my expected profits after 30 days in the trade as a baseline for sizing the downside hedge. For example, if I expect 30-day profits to be $1.5k, then I'll probably spend no more than $150 (10%) on protection for the first month of the campaign, when the structure is most vulnerable.
The design of the hedge will be different as well. Instead of a ratio of VIX calls across expirys, I'll look for a 30-day OTM put debit spread in SPX (income structure is /ES, but size is bigger, commissions are cheaper, and liquidity is better in SPX) trading for .90 to a buck. I'll spend the remaining .50 on a single 30-day VIX call. I like the idea of a mix better, and I like the idea of a naked long in the VIX much better than spreading it off - reason being, I think the VIX may be particularly vulnerable to explosive behavior due to all the short-vol trading, and if so, I don't want to cap gains.
Thanks for input. I like both ways of hedging they seem to be worth of time to explore in future.
Johnyoga: do you have your SPY puts all the time or maybe you just increase size in expected danger? I also trade far OTM but try to hedge in the same instrument (SPX) - mostly for simplicity. Did you calculate long term cost of this method? I assume you are buying 40-60 cents for 10% Gap.
Ice101781: I like 10% approach but I see danger here. 10% is pretty easy to track and it is darn good ratio but will it perform when needed. I'm speculating. You should have decent results long term but also bigger drowdowns (if 10% hedge is less efficient). Are you trying to recover costs after first month?
I run hedge all the time and so far it has been significant drag on my P/L. I will be working on this issue when I finish my pending study but for now I'm leaning toward setting hedges more discretionary way. Unanswered question is: am I willing to take the risk.
To clarify, quote from today's Zerohedge's post (how timely):
"(...) approach to calculating risk failed to take into account the possibility of >>six sigma<< [event]"
First of all, and before I forget again: I enjoy the dialog occurring in this thread. What a wonderful group of folks here!
Hedging in the same instrument is fine of course, and certainly makes the process a pinch simpler. For me, I like to fine tune my hedging, and SPX doesn't do that for me, but the SPY does. I enjoy the tighter spreads, and more expiries to choose from. I appreciate how the Long Puts help out almost immediately to the downside, and certainly cures the potential losses from some of my structures that break below BE at 7% - ish.
Expecting Danger. There are studies at the CBOE website that show when the VIX is under 15 or over 50 you do not hedge. You hedge with 0.5% of your portfolio value using 25% OTM VIX Calls when the VIX is between 15 - 30, and when the VIX is between 30 -50, you hedge with 1%. Translate that to what you are asking: Supposedly, if you see the VIX below 15 or above 50 you do not hedge at all (no VIX; no Long Puts); it's only when the VIX is between 15 - 50 that you do so. But, this study is not speaking to unexpected, out-of-the-blue, Black Swan events. A Black Swan by its very definition, are unexpected. Therefore, on my end, at least, I try to keep the discipline of having a hedge on at all times. Imagine kicking yourself for not placing at least a minor hedge that costs you a cup of Starbucks coffee?
I see that many of us struggle with similar problems. Unfortunately no universal solution exists. I have no experience with SPY but I will look at SPY long puts (typically it will be short term loss, nespa?). I have very reserved approach to financial studies especially when some aspects are obscure to me, in this case I probably wouldn't drop hedges below 15 but rather loosen them, well depends on actual position...
You're right, there are much valuable information here.
Do you have a link to that study?
I agree with Marcas here: no universal solution exists. I even question whether it's worth trying to backtest because so few significant market crashes/corrections exist. Maybe you put these hedges on and just assume to lose in every case (but will be rewarded when a crash happens).
Ice101781--if you take 10% of a monthly income trade and allocate that to weekly hedges then can you really get any protection? I can better see taking 10% of that and allocating them to monthly hedges but I also find the idea of shorter-term hedges to be interesting.
Sure, I'd like to recover the hedging costs in the first month (i.e., in the form of out-sized gains), but my expectation is to earn the 30-day simulated profits less the hedging costs. I'm willing to lose that money - instead, the focus will be on spending no more than 10% for as much protection as possible, using skew to maximize my edge. The idea is to not have to worry about managing losses on those debits.
I think the answer to this question is highly dependent on your trade structure/parameters, but in my case, income trades are being initiated with ~90 DTE and going forward, the hedges will be opened on the same day with ~30 DTE. Again, how much protection you can get for 10% will vary, but I'm satisfied with what I've seen so far.
I have this on my PC desktop. I look at this every so often. This, and I remember the day when the three of us traders were Skyping on an expiration day in October ("years back") when one of them lost half of his account...he was in a shit-ton of Iron Condors. That day screwed him up for years...these are reminders to not be complacent and have portfolio hedging on at all times, and not wrap my trades around or near the axle...
With your comments: It depends on when you start, now doesn't it?
If a person gets hit with losing half or more than half of their account when beginning a delta neutral strategy, it will take 100% (or more) to recoup. The person and his account are already damaged. Unless a person has a large bank, many will be "in" with at least 30% of their bank at one time.
To folks here that have not even been through at least one major crash (via strong, spiky down moves) and/or Black Swan, rationalizing what you will do when it happens is far different than having it happen, or seeing someone you know have it happen to them...it is no longer an academic/rational decision/exercise. The spreads become impossible to deal with; they become eye-popping wide, and the market is moving so fast as to create its own stress.
Two takeaways from Nassim Taleb:
- Don´t try to predict a black swan, instead prepare yourself for a black swan
- It´s a black swan event for the turkey, not for the butcher
When you are long a hedge, it's a beautiful thing to sell into that mess...the widened spreads work in your favor...
Hedges are helpful in sharp downturns (and I have them in place now), but one of the simplest and fastest tricks is simply to buy back a short or two, the end result being net long puts. Yes, it is painful to realize the loss on the shorts, but some of that loss can usually be recovered if/when the market stabilizes and if there is sufficient time to sell additional premium (at a relatively safe distance from the money). However, trying to recover all losses by a martingale approach is foolhardy. By utilizing this simple technique of short-covering, a devastating loss can be avoided, and the experience becomes "the cost of doing business" rather than a career-ending event.
True, Dan. For others reading this that haven't been through a large smack down: the spreads do widen a lot during these periods.
Folks, I have attached hedging research performed by members of the Society of Actuaries. If you have seen this before, my apologies.
Never a truer word, johnyoga
Indeed, this great investors letter*** from Artemis Capital hits the nail on the head, including a nice reminder about Hari Krishnan's "Second Leg Down" book:
Also, this flowchart in the document johnyoga attached is very handy too:
After last week's volatility, I thought I'd add an interesting article to last years discussions that I stumbled upon, written by a retired investment advisor (bought his first stock in 1958!!) that discusses hedging (see below).
On another note, I'm not sure if anyone used the right hand "green box" shown above and had VIX options ahead of time....did they work out as planned?
A lifetime of experience has told me that there is no really effective way to hedge actively against corrections or bear markets.
To expand upon this point of view, I look at implications of a hedge posed by Mad Hedge Fund Trader, a pretty reasonable and simple one.
The problem with hedges is their dependence upon timing and your opinion about when the market, even if overpriced, will correct. Taxes also don't help.
A comparison with active hedging gives cash an advantage and more flexibility in the more likely scenarios, and increasing cash returns narrow the comparison with stocks.
The only other alternative - especially for the young - is simply to buy and hold and ignore market events.
The elevated valuation of the stock market has clearly caused many investors to consider finding a way to hedge their portfolios, and this interest in hedging will undoubtedly grow as investors look at the effect of the recent sell-off on their portfolios. Caution at the present moment is understandable - and a calculated caution is always a good idea - but is there really an effective way to hedge?
Hedges are always a great idea. However, even if your teenie exploded with profit enough to keep your broken wing butterfly t+0 line above water , how much fun will it be trying to take that butterfly off for a reasonable price while the market is tanking and the fly is 80 points away ?
PS I trade BWB’s , and I also think about this
The bid ask was ridiculous last week, pricing for my flies were all over the place. The teenie is there to brace for a gap down vol shock or market closing. I always have a back up plan for markets like last week which is essentially buying a vertical first and then a put (or multiple). Whether that is closing out a short leg of my fly or just buying a put or put spread. Anything more complicated than that is a nightmare to get filled.
Were you able to do the above mentioned last week?
I got some verticals traded and did close out a small bwb (not at a good price), but pricing was all over the place.
I see. Do you run teenies on all your BWB’s?
Just enough to keep my T+0 at an acceptable max loss level. I look at it as a whole not individual bwbs
It is always amazing to see how the price of the teenie explodes in a true vol spike.
I watched an April standard expiry 2-delta SPX 2200 (!!) put move from approx $2.65 at 15:30 Thurs 1st all the way up to approx $25.60 near the close on Monday 5th. That's pretty useful asymmetric price behavior....similar to what Tom mentioned in last week's TG2.