Hedging the VIX & More Stock of the Week

17Apr10

In my last post I reviewed the VIX & More Stock of the Week that I’ve been trading as part of my Play Money Project ($100k funding 10 mechanical strategies radically different than my own).

In truth, I’ve actually been trading the SOTW in two variations. The first is exactly as I described it in my review: buy at the Monday open and sell at the Friday close. The second is a hedged variation that uses index ETFs to reduce market exposure.

As the review showed, the SOTW has generated a lot of alpha, but because it’s a long-only equity program that’s always invested in the market it has also been subject to a lot of beta-risk. Put another way, when the market is performing poorly it’s dragged on returns (and vice-versa).


[logarithmically-scaled, frictionless, weekly-interval]

The graph above shows the hypothetical results of the original SOTW (blue) compared to a hedged variation (red) that’s more or less the same as the one I’ve been trading, versus the ETF SPY (grey) since inception.

In the hedged variation I’ve assumed a trader went long the SOTW each week at Monday’s open, but also (using leverage) shorted an equal dollar amount of the ETF SPY (to offset beta risk).

A couple of important notes:

1. I’m KISS’ing with the hedge. Really hedging beta would require looking at each week’s individual pick and then choosing the offsetting ETF and dollar amount that would be best in that specific circumstance. I don’t do that as part of the Play Money Project, because I’m trying to keep the workload to a minimum. Also note that in my own portfolio I go long RWM rather than short SPY, but more folks are familiar with SPY, so I’m using it here.

2. These results do not account for transaction costs or slippage because trading frictions are very specific to the individual trader. The average/median return per week was 1.52%/1.66%, so there’s quite a bit of meat to work with.

Numbers for the number lovers…

Thoughts on the Hedged Stock of the Week

The hedged variation has created a considerably smoother ride by better isolating just V&M’s stock picking skills. Correlation to the broader market has been near zero and risk-adjusted returns have been improved.

Two flies in the ointment:

1. The hedge creates additional transaction costs, something a smaller investor especially would need to consider.

2. The success of the original SOTW strategy required V&M to pick consistent winners, but the success of the hedged strategy requires V&M to pick consistent outperformers. Those are two entirely different things.

I think it’s a lot easier to pick outperformers in all market types (consider the difficulty, for example, of consistently picking long winners in a bear market), but when picks are flat/negative in a bull market (which has happened a bit this year) the hedge acts as a double-doozy on returns.

[click for a summary of all recent posts about the VIX & More SOTW]

Happy Trading,
ms

P.S. again, I’m not compensated in any way for these posts – I’m just trying to shine the light on the good guys.

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9 Responses to “Hedging the VIX & More Stock of the Week”

  1. 1 Josh

    What are the other “radically different” strategies you’re playing with?

    Josh

    • 2 MarketSci

      RE to Josh: I introduced the concept of the Play Money Project in my previous post. I’ll be talking about other programs over time to break up the subject matter on the blog. More to follow. michael

  2. 3 mg

    I’m somewhat bugged by the hedged strategy graph. The hedge requires additional capital and so the returns are on the total capital right?

    • 4 MarketSci

      RE to mg: I run the hedge on margin in my own Play Money account, so no, no additional capital would be required. Normally I wouldn’t consider such an approach, but because of the (somewhat) beta-neutral nature, I think it might make sense here. michael

  3. 5 Stephen Almond

    I assume the transaction costs for the hedge would be negligible?
    For example, sell short $10,000 of SPY (or buy $10,000 of the inverse) and hold that position forever.
    Then each week, buy $10,000 of the SOTW.
    Would that work?

    Steve

    • 6 MarketSci

      RE to Steve: that would be one way of doing it (and it’s the way I do it for the Play Money Project) – you’ll need to occassionally adjust the hedge when it gets off by more than X%.

      I should note however that that’s not how I ran the test in this post. Here I open the hedge at Mon’s open and closed it at Fri’s close to better match with V&M’s trades.

      michael

  4. 7 Blue

    Hi Michael,

    You wrote that “hedging beta would require looking at each week’s individual pick and then choosing the offsetting ETF …”

    What is the offsetting ETF? Is it the ETF in the same sector? I would expect that selection of stock-of-the-week takes sector into account. So shorting the same sector seems to be self defeating. But what else would make sense other than the “general market”, which is what you do?

    • 8 MarketSci

      RE to blue: good thought. When I wrote that I was thinking more along the lines of Russell 2000, Nasdaq 100, etc. but individual sectors might (or to your point, might not) make sense as well. Would need to test the idea. I don’t know to what degree Bill is considering the sector vs that single stock. michael

  5. 9 heywally

    Late to the party … the thing I like the most about this hedge approach is that it protects you (largely anyway) from sudden ‘black swan’ events. Assuming a certain position size, I’d use the ES, futures to hedge with. Thanks ….


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