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Uncertainty in the market is increasing, which means that investors want to insure themselves against risks. Hedging is one way to protect a portfolio against losses. Hedging with options is a popular method that has a lot of shortcomings. A market-neutral portfolio is a hedging method in which the distinguishing feature is the lack of correlation with the market. A market-neutral portfolio enables investors to make a profit when the market takes a nosedive, but this method has to be used carefully. It’s not uncommon to hear that there is a bubble forming in the market. The more a market grows, the more participants start to voice such concerns and the more convincing their arguments sound. However, aside from bubbles such as the dotcom crash in 2000 or the crisis of 2008, there are other situations that impact investors negatively. The slowdown of the Chinese economy, the crisis in Greece and the expectation of increases in interest rates are all factors of uncertainty that put pressure on the market this year. The increase in uncertainty on the market means that a lot of investors want to insure themselves against risks and retain profits made during years of rapid growth. The simplest way to protect yourself against risks is to have a cash position. This position is the least affected by risks and allows investors to take advantage of the opportunities that may present themselves if the market crashes. For example, the recent Flash Crash allowed market participants to purchase stocks of great companies at low prices. Nonetheless, cash positions have one major disadvantage – during periods of market growth, they significantly limit potential returns. Hedging is another way to insure a portfolio against risks. A hedge is a position in an instrument that serves to decrease potential losses on a position in another instrument. Hedging with options is one of the most popular ways to hedge. Options can be used to create all sorts of different hedging strategies. Let’s look at a few basic examples. Protective puts . One of the simplest hedging strategies – the purchase of put options with a strike price at the level of tolerable losses. Let’s look at a scenario in which an investor purchases a stock for $100 and in which the amount he/she is willing to lose is 15%. After purchasing a put option with a strike price of $85, the investor will ensure that the most he or she will lose is 15%. The investor is paying a premium when he/she buys put options – essentially paying for insurance against risk. Collar . The premium an investor must pay to purchase a put option can be quite large. The system of hedging a portfolio with a collar allows to decrease these risk insurance costs. In this strategy, the investor simultaneously purchases a protective put and sells an out-of-the-money call option. By selling the call option, the investor receives a premium that can cover part of the expenses for purchasing the put option. In some cases, the premium received from the sale of a call option can be higher than the premium spent for the purchase of the put option. Thus, the investor essentially gets paid for hedging their position. However, in selling the call option, the investor limits potential income from the long position. This is why the collar strategy only makes sense if the investor expects the price of stocks they purchase to not exceed the strike price of call options they sell. In spite of the popularity of these strategies, hedging with options has a number of serious disadvantages. First, the options market is too difficult to navigate for many individual investors, which is why they prefer to not trade instruments they don’t understand. Second, liquid options don’t exist for all securities, or premiums on the options can be very high. Options strategies described above help to limit losses of the portfolio. But smarter way of hedging is reducing the exposures of the portfolio to different kinds of risk. A better hedge is one that would not only cut down on potential losses, but would eliminate a portfolio’s correlation with the market and other risk factors such as sector specifics (this is relevant, for example, for the Energy sector, which dropped significantly when oil prices fell). A market-neutral portfolio is one such hedging strategy. The idea behind a market-neutral portfolio is that the investor takes a long position on a number of instruments in the portfolio, and shorts the rest. In this way, if the portfolio is put together correctly, there is an opportunity to make profits regardless of how the market behaves. The most popular example of a market-neutral portfolio strategy is pair trading, which is when an investor takes long position in one stock and shorts another (with different weights) in case of widening of spread between their prices. The expectation is that the spread will eventually be become narrower. Pair trading is quite simple in theory, but difficult to carry out in practice. In order to be implemented successfully, investors have to find the right pairs to pair trade. It is best to have more than one pair so that a potential loss on one would be covered by profits from the others. Moreover, it is necessary to determine the weights on long and short positions in each pair, since the securities can have different beta coefficients against the market. Pair trading opportunities do not come up systemically, which is why an investor has to constantly monitor pairs – not a good strategy for those who prefer to only trade occasionally. There has to be a stop-loss for each pair, since the difference between each pair may never diminish, but rather continue to increase in the future. Finally, broker commissions for short positions may make opening a short position on a security in a potential pair impossible. A much simpler implementation of the market-neutral portfolio strategy is as follows. The investor longs stocks and shorts index futures (with adjustment for the beta of the long part of the portfolio against the index). This portfolio would have a correlation with market that is close to zero because of the short part. Profits will depend on how much better than the market the long stocks perform on a risk-adjusted basis. In other words, this portfolio will allow the investor to extract the alpha of securities in the long position. With the development of ETFs, constructing such portfolios has become a lot easier. Instead of shorting futures (the price of E-mini futures does not allow investors to use them to hedge small portfolios), inverse ETFs can be used – ProShares Short S&P 500 ETF (NYSEARCA: SH ), for example. Moreover, sector risks can be hedged by using sector ETFs as hedges. An investor could profit on recent biotech plunge by hedging portfolio of best biotech stocks with iShares Nasdaq Biotechnology ETF (NASDAQ: IBB ). An important advantage of this portfolio is the fact that it does not require a large number of trades. All the investor has to do is occasionally correct the size of the position in the hedge to make sure that it doesn’t differ too much from the long position (with respect to the beta). Here is an example of a backtesting of implementation market-neutral portfolio strategy. We conduct backtesting, starting on 01/01/2008. The backtesting period’s start date was set to 01/01/2008 to include periods of both market decline and market growth. We apply simple screening to choose stocks for the portfolio. On the first step of the screening we limit the universe of 500 US companies with the largest market cap to 100 with the lowest 1-year volatility. On the second step we pick top 20 stocks by dividend yield from 100 stocks that have been chosen on previous step. This portfolio presumably should generate excess return against the market on a risk-adjusted basis. In order to make portfolio “market neutral” we should add hedge to the portfolio. As a hedge we would use short position in SPY. The proportion of assets allocated in hedge should be equal to beta of the portfolio against hedge. Then beta of the hedged portfolio would be equal to zero. In other words, hedged portfolio would be market-neutral portfolio. We would rebalance this portfolio quarterly. Rebalancing is necessary because: It insures that stocks in the portfolio match our screening criteria; It helps to adjust allocation of assets in long and short parts of the portfolio, so that the beta of hedged portfolio would be zero. Beta of the portfolio is recalculated on each rebalancing date. (click to enlarge) At the selected interval, the portfolio has an Annualized Return that is comparable to S&P 500 (NYSEARCA: SPY ). The Maximum Drawdown is much lower, while the Sharpe Ratio is higher. Of course, hedging a portfolio like this is not free. In this case, the price is that a neutral portfolio will show moderate returns during market boom periods. Investing always involves risk: the market is volatile, and this volatility is influenced by both fundamental factors and by noise. Forecasting a market drop is almost impossible, which is why it makes sense to hedge portfolios during periods of uncertainty in order to avoid significant losses. A market-neutral portfolio is a type of hedging that allows investors to limit losses and make profits in any market conditions, since the profitability of such portfolios does not depend on market shifts. But during market booms, such portfolios will be less profitable than regular ones. This is why investors with moderate risk tolerance can employ this hedging strategy periodically, when uncertainty is high. Scalper1 News
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