Tag: options

Practical Momentum Part III – Hedging

Introduction

In Part II of our Practical Momentum series, we saw how adding a volatility adjustment significantly improved portfolio returns. However, we were left with a nagging observation that long-only returns were much higher than long-short returns. The problem with a long-only futures portfolio is that draw-downs can wipe you out. But what if we hedged the portfolio?

You can hedge a portfolio in two ways: (a) buy individual put options, and (b) calculate the beta of the portfolio and short an appropriate multiple of NIFTY futures. The problem with option (b) is that it will not protect you against idiosyncratic risk. For example, say you are long a pharma stock and the USFDA issues an import alert, the stock will tank irrespective of the NIFTY. So for the purposes of this simulation, we will try option (a)

Hedged Long-Only Momentum

With 5 long-futures hedged with long put-options below the purchase price:

black line shows long-only; red shows hedged long-only

hedged.momentum

A portfolio hedged with single-name put options performs poorly:

  • There is always a d between the option payout and the underlying
  • ?-decay eats away more of the option value than the protection it offers

Another way to make draw-downs shallower is to diversify. When we increased the number of stocks in our long-only equity momentum portfolio from 10 to 20, it reduced portfolio volatility and boosted returns. Here’s how a 10-count long-only momentum portfolio compares with the 5 from above:

black line shows a 5-item long-only portfolio returns; red shows 10
five10.momentum

Conclusion

The problem with leveraged momentum is that losses can wipe you out. Hedging it with single-name options doesn’t work. Are we stuck with unlevered momentum? We will explore this in the next post. Stay tuned!

Categories , Tags , ,

Covered Call Strategy Cheat Sheet

Paper from the brain-trust at AQR Capital Management: Covered Calls and Their Unintended Reversal Bet is a must read for anybody trading options.

Simply put, a covered call is when you own the underlying stock and you sell a call on it. If the stock doesn’t go beyond the strike at which you sold the call, then you pocket the premium. Otherwise, your upside on owning the stock is capped at the strike.

The payoff diagram of a covered call looks like this:

covered call payoff

The authors claim that over a quarter of a covered call’s risk may be attributed to market timing and investors are ignoring its effect on returns.

Because a covered call option strategy reflects an underlying position in equity (delta = 1) and being short a call with changing delta, we get the following situation:

  1. Baseline situation: equity delta = 1.0 and short call position delta = -0.5; net 0.5 delta
  2. In a falling market environment: equity delta = 1.0 and short call position delta = -0.25; net 0.75 delta, or higher market exposure
  3. In a rising market environment: equity delta = 1.0 and short call position delta = -0.75; net 0.25 delta, or lower market exposure

The insight: a covered call strategy embeds elements of a reversal strategy, not a trend-following strategy.

The cheat sheet

  1. Bearish on volatility? Don’t do a covered call.
  2. Bearish on the market? Don’t do a covered call.
  3. Like trend-following? Don’t do a covered call.

Sources

  • Covered Calls and Their Unintended Reversal Bet (pdf)
  • Own the Stock and Sell Calls: Guaranteed Win, Right? (AlphaArchitect)
Categories , Tags

Beyond Payoff Diagrams

In our previous post, we discussed how you can use a Nifty May 6600/6750 Long Put Spread to express a bearish view. However, the payoff diagram, only shows the P&L at expiry. The underlying can take a completely random path towards that payoff, impacting your daily mark-to-market.

Visualizing θ

One way to visualize it to keep all inputs to the model the same and compute the prices of the the options at different price points. Additionally, you can also plot historical values of your spread to give you an idea of where they are at.

NIFTY 6600-6750 Long Put Spread

Note: y-axis is not P&L

As you can see, its only at the very end of the spread’s life that its model value gets pulled towards the values shown in the payoff diagram. This is largely due to θ-decay.

Takeaways

If you are in-the-money on your spreads, then it makes sense to keep the position open till expiry. Most of the gains are accrued at the fag-end of the term.

Categories , Tags