Posted March 10, 2011 by Dynamic Hedge

www.dynamichedge.com

Everyone has an opinion on how to hedge positions.  Dont let all the talk of beta, theta, gamma rays confuse you.  Its not hard or overly complicated to hedge a position.  First thing you have to realize is that you shouldnt try and limit your risk 100% because it is simply impossible.  Traders get caught up in the fourth decimal place.  Free yourself from slavery to precision and you can hedge effectively, not perfectly.

Hedging positions is all about adding something that will reduce your overall risk.  If you have a long portfolio you may want to add some short exposure that will profit if the market goes down.  Likewise, if youre short, you may want some long exposure to hedge against a market rise.  If you have too much exposure to one sector or risk factor you need to add a little diversification into the mix to limit the risk concentration.  You need to identify a good hedging instrument for your situation.  For now, well just focus on the different ways of balancing a long or short portfolio.

Instruments:

• SPY. DIA. IWM Use these broad market indexes if you just need broad exposure to market direction.  If youve picked a portfolio and had a decent run, you may want to add some protection.  Shorting these instruments will give you exposure that tracks well and will give you the risk you are looking for.
• SDS. SSO. FAS. FAZ Leveraged ETFs are a little bit of a different animal.  They are generally designed to reproduce the daily returns of the index they track, therefore eroding some of the hedging juice in volatile markets, and slowly decaying in quiet markets.  A quick google search will educate you as to all that is wrong with these instruments.  Basically they are only good to hold for a few weeks, tops.
• Other correlated stocks or sector ETFs If you have a stock that you want to hedge just find the sector ETF that it belongs to and hedge with that.  If you are long an oil company, think about hedging with the XLE or OIH .  Or create a pairs trade by picking a stock to short that is well correlated to your long position but has terrible fundamentals.  Check out market-toplogy.com for a decent free correlation tool.
• Options Beyond the scope of this post.
• Volatility derivatives VIX options, VIX futures, VXX etc, are all decaying in a similar manner to the leveraged ETFs.  I would recommend staying away unless you have a very short time horizon, or youre a warlock wizard trading god.

Calculate the hedge:

Dollar balancing Lets say youve got $100,000 worth of long stock.  Simply take $100,000 and divide by the current price of SPY (or other non-leveraged market index).  The number you get is the number of SPY shares you need to sell short to dollar balance your portfolio.  This is the rough and dirty way to quickly hedge a position.  Not ideal, but necessary in some cases.

Beta balancing You will want to do these calculations if you plan on holding a hedge for more than a few days.  First, go through your stocks one by one and get the beta for each.  The beta for SPY will be 1 or very close to it (if not, your data is screwed).  Multiply each stock beta by the proportion of your portfolio that it represents.  Add those numbers up for the total beta of your portfolio.  Take this example portfolio: 50% UNP. 25% is CME. and 25% is CSCO .  Based on current beta, you would multiply (0.5 * 1.17 UNP ) + (0.25 * 1.13 CME ) + (0.25 * 1.12 CSCO ) = 1.15.  Multiply the value of your portfolio by 1.15 and divide by the price of SPY.  Thats how many shares of SPY you need to hedge.  If you are hedging with an instrument with a different beta than 1, divide the portfolio beta by the hedge beta.  Multiply your total portfolio value by the result and then divide by the price of the hedge.  This is the total number of shares you need to beta balance.

This is all assuming that you want to hedge your entire position.  You can modify the quantity to cover a portion of your total position, or you can hedge more than your entire position and essentially make a short-term contra bet.  The decision is yours.

A couple side notes: Some betas make absolutely no sense.  The current beta for DIA is -0.11?!  Use your judgment here.  Also, dont use this formula when the betas have a huge differential, like 1.4 vs 0.1.  There must be a minimum and maximum constraint.  Otherwise youll get massively skewed sizing which will have very little to do with the way that the instruments are likely to perform in the future.  Use common sense.

Also, if you have the problem of too much exposure or too much risk the best hedge may be to just reduce the size of your position.  Seriously.

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