Hedging trend following - critique this plan?

A

amooseman

I'd like to hedge a simple trend following strategy that goes long the market when it's above the 200 daily moving average, trading once per month. Basically, I am comfortable using some leverage and taking a loss on the first few points down but don't want to risk a 1987 style gap down before I can exit my position.

Here is the plan:
Long 100 SPY
Buy 1 SPY LEAP put at the 200 dma. This will be a long dated put rolled once a year.
Sell 1 monthly SPY put 10% below the 200 dma each month. This is to decrease the cost long dated put.

Does this make sense? Am I missing some flaws with this hedge? Would you recommend something different?
 
That's a workable plan. Keep in mind that (by design) your delta exposure will change over time, and (perhaps not by design) that your margin requirements will change over time because the short put will not always be completely covered by the LEAPS put.

If you're doing this in a taxable account, consult a CPA about the potential tax consequences of the short puts as well as the protective put.

You may also want to add more diversification in terms of the system's parameters as well as in the underlying ETFs you're using.

Also, it's not 100% clear to me whether you're describing the entire system or using the system as a hedge to a different, completely separate trend-following system. The plan as you've currently described it isn't strictly trend-following, although it might do enough as a hedge that you feel okay about it.
 
Reformed Trader said:
That's a workable plan. Keep in mind that (by design) your delta exposure will change over time, and (perhaps not by design) that your margin requirements will change over time because the short put will not always be completely covered by the LEAPS put.

If you're doing this in a taxable account, consult a CPA about the potential tax consequences of the short puts as well as the protective put.

You may also want to add more diversification in terms of the system's parameters as well as in the underlying ETFs you're using.

Also, it's not 100% clear to me whether you're describing the entire system or using the system as a hedge to a different, completely separate trend-following system. The plan as you've currently described it isn't strictly trend-following, although it might do enough as a hedge that you feel okay about it.
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Thanks. The trend following part of the system is to be long SPY above the 200 dma and in bonds below the 200 dma, checking on a monthly basis. The put spread is the hedge to that system in case the break below the 200 dma is very severe before the system exits the long SPY position.

I have other indicators to hopefully avoid leverage in a black swan environment in addition to non-equity strategies, but I'd feel better using leverage if I had some cheap insurance like the proposed put spreads.

I'm aware that the 2 weaknesses of trend following are 1) whipsaw and 2) the flash crash. The hedge is to deal with the flash crash, but maybe there are better ones. An option strategy that could also do well during flat and volatile whipsaw environments may also help the overall portfolio.
 
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Yes, I think it's a good idea to add negatively correlated strategies. Selling strangles would help reduce the problem with whipsaws but comes with its own set of problems (increased leverage and the possibility of margin calls).

Even though I have several different types of hedges on at the same time, I personally don't like naked risk, whether it comes from selling options or buying stock on margin. Brokers typically charge more in interest than it would to create similar positions synthetically, and margin requirements can change unexpectedly, especially if you're trading something like UVXY.

I realize that limits the strategies I can use - I can't trade 1x2 put ratio spreads or naked short stocks, no matter how attractive those strategies look theoretically - but I can sleep at night. If the power goes out or I have to go to the hospital, my account won't blow up on account of anything I have prior control over. It also means that I can put trades on and take them off when the market is quiet, which allows me to work spreads a lot better.

[EDIT: I've found this podcast episode pretty insightful: Daymond John and The Power of Broke. Being forced to trade or start a business with lots of capital constraints forces people to become creative and make better products.]

Have you found a way to limit the costs and margin call risks of leveraging up the trend-following strategy? I'm always interested in hearing new ideas.
 
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amooseman said:
I'd like to hedge a simple trend following strategy that goes long the market when it's above the 200 daily moving average, trading once per month. Basically, I am comfortable using some leverage and taking a loss on the first few points down but don't want to risk a 1987 style gap down before I can exit my position.

Here is the plan:
Long 100 SPY
Buy 1 SPY LEAP put at the 200 dma. This will be a long dated put rolled once a year.
Sell 1 monthly SPY put 10% below the 200 dma each month. This is to decrease the cost long dated put.

Does this make sense? Am I missing some flaws with this hedge? Would you recommend something different?
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Yes skip the put, in an uptrending bull market. BUT if you already are in the put, wait until Oct to close it out.

Good thing about SPY/QQQ /IWM markets; most of the move is not in an OCT gap. SEPT 1987 was down.............................................................................................................Learn to earn enough to insure some stuff yourself, like your auto also; even though liability is so cheap, may want to buy that -i do ......:cool::cool: Even the worst of the bunch in 1987, IWM, which i dont consider as liquid as SPY, has done much better in bear markets, since 1987.If they did CRASH trade towers again, which is pretty likely i think,or something like that, i may sell, slow LOL, QQQ before SPY; QQQ has always been more roller coaster.
 
Surprised no one has pointed out that long 100 shares SPY + 1 LEAP put is synthetically equivalent to buying 1 LEAP call at the same strike. You can free up a ton of capital by just buying the call. Maybe sell some short term OTM calls to reduce carry.
 
To expand more on your point about synthetics, it might actually make sense to dump the stock, trade the LEAPS diagonals, and use the money to pay down mortgage debt. The call would allow him to borrow money at 2.7% and pay down debt at 5% or more.
 
Reformed Trader said:
I agree, but I think amooseman wants to trend-follow the SPY position and use the put diagonal to hedge against brief, moderately sized down moves.

Replacing buy-and-hold SPY with a call and selling OTM calls (equivalent to a diagonal collar) does have favorable risk-reward characteristics:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1133509
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Great study thanks for sharing.

Where does one find more of this type of study?
 
The easiest way I've found to do it is to go to CXO Advisory and use the search box:
https://www.cxoadvisory.com/

The studies you'll find tend to be limited in scope. For example, that "Collaring the Cubes" study picked a time period that contained two bear markets and used the sector of the market that had declined the most, so it's going to generate numbers that look better than if, for example, they had used SPY or a value ETF.

You can also go on Twitter and follow people who seem to have an academically oriented mindset.

A third way is to think about the sort of risk you want to mitigate - for example, the 1987 crash - and search Google for papers related to strategies that you think would work. Seeing the strategies actually tested can be eye-opening. Buying front-month put options, for example, would seem to have worked well but actually didn't because the puts were so expensive during the period before and after the crash.
 
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