Hedging To Limit Risk

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David Pinsen, the founder of Portfolio Armor, discusses the The Hedged Portfolio Method.

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What Is A Hedge

  • A hedge is something that always goes up in value when an underlying security goes down in value significantly.
  • If you want to hedge stocks, other asset classes such as gold, or bonds are not hedges.

Black Swans: Why Hedge Individual Stocks

  • JP Morgan Study: 40% of Russell 3000 stocks suffered catastrophic losses between 1980 and 2014.
  • "Catastrophic loss" defined as a decline of 70% without recovering.
  • 57% of information technology stocks experienced catastrophic declines during this period.
  • Black swan examples: 2008 Financial Crisis, 2020 COVID-19 (e.g., cruise ships, REITs), antitrust action.

Black Rain: Hedging Portfolio And Market Risk

September 18th, 1989.

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Black Rain

Black Rain

The Most Effective Hedge: Put Options

Most Effective Hedge

  • Protection even if the underlying security goes to zero.
  • Non-linearity means a little goes a long way, so less drag on returns.

Minimizing The Cost Of Hedging

Minimizing The Cost Of Hedging

  • Decide how much you're willing to risk
  • Look at OTM puts
  • What's your max drawdown including hedging cost?
  • Compare annualized cost as a % of position value
  • (SPY $310..62 on Monday)

Minimizing Cost With Collars

Minimizing Cost With Collars

  • Giving up potential upside to reduce the cost of hedging.

How Much Should You Pay To Hedge?

  • How much are you up on a position you can't sell?
  • For other positions, is the cost of hedging greater than your expected return?

Starting From Scratch: The Hedged Portfolio Method

  • Start with universe of hedgeable securities.
  • Estimate potential returns for them.
  • Calculate their hedging costs.
  • Subtract hedging cost from potential returns.
  • Sort by potential return net of hedging cost.
  • Buy and hedge a handful of the names at the top of the list.

Top Names Performance, Unhedged

Top Names Performance, Unhedged

  • Have outperformed SPY by 0.62% so far.
  • Working to increase outperformance.

Hedged Portfolio Example, 12/26/2019

Hedged Portfolio

Performance Of That Hedged Portfolio

Performance Of That Hedged Portfolio

Putting Together A Hedged Portfolio

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  • Our hedging tool scans for optimal hedges.
  • Our hedged portfolio construction tool creates portfolios following the hedged portfolio method, designed to maximize your returns while strictly limiting risk.
  • Website: PortfolioArmor.com
  • Coupon code for Portfolio Armor website: SFAAII.