Last week, we published a brief article on steps we took to hedge portfolio risk in advance of the Brexit referendum. This article updates that one and serves as a post-mortem analysis of the investment.
Let me preface this by saying that one of the reasons I am suspicious about hedging is that I have rarely seen hedges that were value creative to an investor. My hedge on the S&P 500 ETF in preparation for the Brexit referendum was completely unsuccessful at its intended purpose, so is not an exception.
Even going into the transaction, I knew that if the market failed to fall the point 10% below the level of the S&P when I purchased the protection (the level at which my options were struck), I would not have any idea when to close the transaction, and if so, how much of the position to close. This is the essential difficulty with any investment analysis tied to the price of an asset: if the price signal is not clear, what action should one take?
While the market’s reaction to the Leave vote was sharp, it was not sharp to the tune of a 10% drop. As such, I was left trying to subjectively decide whether the market had fallen enough for me to take profits.
Last Friday’s markets ended up nearly 4% down and my put option contracts had seen roughly a quadrupling in price. Uncertain of how much further the index might fall, though, I went into the weekend with the option position still in place.
On Monday, markets fell again, so I logged on with the intent to close some part of my position. However, doing so, I was faced with a loss of about half of the previous Friday’s winnings, for two reasons:
- I had left a short-tenor option open over a weekend. Time value slips away from an option whether the market is open or not, so some portion of the value melted away while I was out trimming my shrubs.
- Even though the market fell the next day, the drop was not as great and implied volatility levels fell a bit.
Between the time value shrinkage and the drop in volatility, I realized that my position had merely doubled. As such, I closed half – this realized profits equal to the amount I had spent on the contracts in the first place. At least my hedge was paid for (including commissions and fees!), but my portfolio had still suffered an unrealized loss since I made the transaction and the value of my put protection was rapidly falling.
At least this outcome was better – being neutral – than several readers who wrote in to tell me that they had done something similar before the Brexit referendum, but had decided to close their positions on the day of the voting because the US stock indices had performed so well (this was before the news of the Leave vote came out, obviously). This means that they spent money, realized a trading loss, and wound up unprotected to boot.
Looking back on it, I wonder about my own motivations to make this hedging transaction. Perhaps I was influenced by reports that several prominent, respected investors were positioning for an equity fall (herding bias). If this is the case, my remaining hedge, which is comprised of of very short-tenor options, does me virtually no good at all. Every moment of the long Fourth of July weekend will be eating away at the already paltry value of my option contracts, so if the market is headed for a correction, I will most likely be left out in the cold.
Hedging is an attractive option strategy, but is blindingly difficult to execute well, even for people who have made this their profession. I will think more about the likely longer term effects of Brexit and the arguments of the bearish investors. In the meantime, though, I feel more content spending time analyzing stocks than designing a hedging strategy.