Hedging – A beta Perspective

Every shorter of volatility has asked at one time or another if there is an effective way to hedge their position, and despite years of searching, discussing, testing, I’ve concluded that there is not for some basic reasons

What is a Hedge?

Hedges are an insurance policy to protect something else, and a hedge would be considered viable if it was relatively inexpensive for the protection it afforded. For this we need leverage of some kind which equates to a using an instrument with a higher beta than what you are protecting. If you have a portfolio with a SPX beta weighting of 1.0, then hedging using a higher beta instrument like VIX Call or SPX Put options makes a lot of sense.

What is what you are trying to protect already has a high beta? Well you need to find something with even higher beta to defend it efficiently. UVXY has been described as a loaded gun pointing at your head, so the challenge is to find a more powerful loaded gun for hedging, but I can’t find one out there. I’ve been presented with many; “how about using these VXX options” or constructing arcane spreads as possible solutions, but after simulating the impact of those ‘hedges’, the results were no different than just trading smaller.

There are many pairs style trades that can be implemented, but ultimately rely on well timed exits and entries that could be better used as pure directional plays.

What to do?

Risk defined spreads already contain a hedge but also greatly limit your reward (Capital Markets theory again). More tactical approaches can use a stop loss (either as an open order or a manual process). Still others can use a ‘Doomsday’ prevention position like using an allocation of VX contracts to soften a big move against.

Ultimately it comes down to your personal risk tolerance and confidence in the hedge method chosen as there is no gaming of the risk/reward equation