There is an informative article at WSJ.com this morning that interviewed a certain Dr. Abbott: “In his off hours, he invests with borrowed money, shorts stocks and has taken a complex options position called a “short strangle” on wheat. He has been trying to bulletproof his portfolio against sudden market declines, using investment tools usually associated with hedge funds and banks. But rather than protecting his $1 million or so in holdings, the 35-year-old physician says he left it vulnerable. . . .Now these small investors are facing the same problems as Wall Street pros: Many of the hedges aren’t working as they expected.”
Hedging a Portfolio: Not Rocket Science
Putting on a hedge that actually protects the portfolio is not that difficult to do. The equation is in every quant textbook.
The only difference between an investor and a professional is that the latter knows about the well-documented phenomenon where, when the market blows up, the correlation of all the assets in a portfolio tends to converge to one, that is, everything goes down. At once.
Where it goes wrong for the professional is this: either he thought he had it covered, or (more likely) the drag on performance by the cost of real hedging lowers returns, discouraging investors, so he went without.
For example, if an investor is long 50 GOOG, 200 CAT, 100 AMZN, 75 AAPL, 300 CSCO, and 300 GE, and wants to protect against Armageddon, he would have to be short the equivalent of 1,749 shares of QQQQ at this very moment to protect his portfolio dollar for dollar.
There are lots of ways to skin the cat. The problem is the cost, not to mention the opportunity cost, so the question is this: Do you put on a Doomsday hedge for the full value? Or protect just a portion? Or protect it under certain circumstances?
Further Reading: