Formula For Volatility Adjusted SPY Hedge

Rationalize · Mar 23, 2012

Quote from rmorse:

I think the issue here is simple. You've done your homework and put together a portfolio of longs and shorts. You believe the stocks your short will under perform the market. You believe the stocks your long will perform better then market. I would want to take out market risk. If SPY does not track with your portfolio, and another ETF does, use that.

If you're a billion $ fund, would I get more complicated, maybe. A simple dollar neutral strategy will help you with highly correlated large marker moves.

Bob

If an ETF tracks your portfolio, you trade the ETF.

Rationalize · Mar 23, 2012

Quote from newwurldmn:

Yeah it is. It's also making a volatility assumption. But if you are net long 100k of bac clearly 100k of spy won't be a sufficient hedge. And of you are short 100k of NLy the. 100k of spy would be an over hedge.

Whatever ratio you use will be more art and science, but you need to account for the correlation an the vol somehow and beta does that kind of.

kind of

I'd still net the deltas first, then hedge the residual.

Issue here than annoys me is the SPY hedge may add risk, depending on the OP's basket.

newwurldmn · Mar 23, 2012

Quote from Rationalize:

kind of

I'd still net the deltas first, then hedge the residual.

Issue here than annoys me is the SPY hedge may add risk, depending on the OP's basket.

Yeah. The hedge would be:

SUM(beta*quantity*price)/priceSPY

So you if you are long BAC and short GS in equal notional then the GS would hedge a good chunk of the BAC.

You are right about not getting a good hedge. You will have a lot of basis risk - but that's why the OP has the position in the first place. He's trying to eliminate the market risk, and he may not even do that.

Rationalize · Mar 23, 2012

Quote from newwurldmn:

Yeah. The hedge would be:

SUM(beta*quantity*price)/priceSPY

So you if you are long BAC and short GS in equal notional then the GS would hedge a good chunk of the BAC.

You are right about not getting a good hedge. You will have a lot of basis risk - but that's why the OP has the position in the first place. He's trying to eliminate the market risk, and he may not even do that.

Agreed.

jayjay121 · Mar 23, 2012

i realise that i will not be able to eliminate all risk. The idea is to protect myself if things go completely one side, even then i would lose and not be able to completely save the day, but difference is i want to still be in business and not wiped out, so must hedge for black swan event.

ive just backtested the simple formula and my large winner days were smaller with the hedge and the large losing days were also smaller as expected. So curve is smoother but return is less. But i take the smoother curve anyday.

Im not pair trading. I want to be able to select all stocks that fit my critria on that day without worrying too much about main market direction. This means on some days i will be too long or too short. yes these days do produce the best win days but when wrong the losses can be tough.

So with all that in mind is the first formula (total postions value/SPY price) the most ideal for my purpose?, or should i use the one above with the beta added in it?

Rationalize · Mar 23, 2012

How is this not a pairs trade?

HurricaneUS · Mar 23, 2012

Quote from jayjay121:

i realise that i will not be able to eliminate all risk. The idea is to protect myself if things go completely one side, even then i would lose and not be able to completely save the day, but difference is i want to still be in business and not wiped out, so must hedge for black swan event.

ive just backtested the simple formula and my large winner days were smaller with the hedge and the large losing days were also smaller as expected. So curve is smoother but return is less. But i take the smoother curve anyday.

Im not pair trading. I want to be able to select all stocks that fit my critria on that day without worrying too much about main market direction. This means on some days i will be too long or too short. yes these days do produce the best win days but when wrong the losses can be tough.

So with all that in mind is the first formula (total postions value/SPY price) the most ideal for my purpose?, or should i use the one above with the beta added in it?

what happens if one of your stocks reports an accounting irregularity that was overlooked by the auditors and the company is in fact insolvent?

in addition to market hedging you will also need company risk hedging via options on oversized positions and/or proper money management (ie never risk more than 2% of account on any one position) and/or proper diversification...

..do you see how this can get very complicated very quickly?....

jayjay121 · Mar 23, 2012

hi, yes i see how it can become complicated so simple is best. It does not have to fit perfectly.

It is not a pair trade because pair trading takes into account sector, correlation and normally goes against another stock within the pair. Im just selecting stocks based on my critria, and this could give a very different basket each day. So im not concerned with sector or correlation when my strategy picks a stock. I am though concerned with overall market direction therefore i need the hedge if i become too long or too short within the basket.

Correct me if im wrong as i felt this is not pair trading. Im not looking for pairs specifically. It could be anything.

Also for the money management part, yes im only risking 1% of my account per trade based on average daily range.

Im not very good with math formula's hence why i ask the question. Just looking for a good formula i can use in excel that quickly protects me if needed.

kind regards,

Rationalize · Mar 23, 2012

Quote from jayjay121:

hi, yes i see how it can become complicated so simple is best. It does not have to fit perfectly.

It is not a pair trade because pair trading takes into account sector, correlation and normally goes against another stock within the pair. Im just selecting stocks based on my critria, and this could give a very different basket each day. So im not concerned with sector or correlation when my strategy picks a stock. I am though concerned with overall market direction therefore i need the hedge if i become too long or too short within the basket.

Correct me if im wrong as i felt this is not pair trading. Im not looking for pairs specifically. It could be anything.

Also for the money management part, yes im only risking 1% of my account per trade based on average daily range.

kind regards,

So, your expecting the longs to go up, and the shorts to go down in isolation. Not in relation to each other.

Which means you're expecting your selection produces absolute winners per trade, not relative winners within a paired basket.

On net here, we seem to be hedging your stock selection criteria.

jayjay121 · Mar 23, 2012

yes correct.

so are you saying im better off without the hedge?

but what if the basket becomes too one sided?. Stocks do move on their own merit but if i feel i may need something if something major is happening with the main cash markets, dont you agree?