I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Friday Flash, I share an epiphany or aha moment from the past week.
You might be surprised to learn, as I was, that you can improve your portfolio’s realized returns by adding a hedge that reduces portfolio variance, even if that hedge has negative expected returns on its own!
This feels counterintuitive. I’ve always thought that a hedge with negative expected returns would reduce overall portfolio returns. But what a hedge can do, if constructed right, is smooth returns so that, when your “main” portfolio components (the ones with positive expected returns) falter, your hedge steps in and keeps losses from hurting you so much. Then you have less distance to cover to start making positive returns from the main portfolio components.
I learned about this in The Case for Shorting by Greg Obenshain of Verdad Research. He writes about why this works:
The explanation is mechanical. Over any period, the realized (compounded) return of a strategy is approximately:
This relationship, used by Kelly, Shannon, and Thorp, captures the effect of volatility drag: the gap between the arithmetic average return and the geometric (compounded) return. Average return is what we optimize ex ante. In any given period, the expected return of a portfolio is just the weighted average of the expected returns of its components. Variance determines how much of that return we keep. Higher volatility reduces the fraction of the average return that compounds.
And:
Reducing volatility directly increases realized returns, even if average returns are unchanged. A short that lowers portfolio variance can improve compounded returns, even if it has negative expected returns on its own. Conversely, a short that adds variance will reduce compounded returns, regardless of its correlation. Below we show the volatility drag at various portfolio standard deviations to show how much return is available from volatility reduction.
Applying this to my short put portfolio
I knew theoretically that holding a bunch of short puts, in expectation of keeping the credits when they expired worthless, posed big risk during a market downturn. I’ve seen that play out over the past couple weeks as many of my positions came under significant pressure, as semiconductor, other tech, energy, and precious metals all took a downturn.
I started to play around with short stock positions and long puts, but didn’t have a way to think about how to do this. Would I only enter long puts when the market and charts looked weak? It wouldn’t make sense to do it all the time it would seem, because then I’d just be bleeding money from premiums.
But this idea of reducing variance suggests that actually holding long puts as hedges at all times would improve my realized portfolio returns, even though that part of the portfolio would have negative expected returns (out-of-the-money puts generally expire worthless, especially if you don’t spend much money on them).
My plan going forward is to hedge my long positions with correlated long puts, for example long puts on $QQQ (for growth stocks), or $XLE for energy stocks, or $GLD for precious metals. I will plan to hold this “insurance” at all times, because it’s impossible to predict when the market may fall, and because puts become much more expensive once it does.
My not-so-trusty AI companions1 have offered a couple suggested rules for determining how much put insurance to buy:
- Gemini suggested using 15% of collected premium
- Claude suggested calculating total delta of the portfolio (or the segment I’m trying to protect) and purchasing a percentage delta in puts — enough to offset 20 to 50% of that delta.
As an example of the second approach: if a short put has a delta of -0.30 and I’ve purchased five contracts, that gives me a total delta exposure of -150. I would then buy enough long puts to get me to say 45 delta total.
A missing piece of my plan
This gives me a way to continue pursuing the options wheel without leaving myself open to disaster in case of a market pullback. As to how it will actually work in practice, I guess ideally I’d run some sort of backtest. That sounds like too much work, so I’m just going to move forward with a basic plan and see how it does. Of course this is the sort of thing that plays out over years.
Part of what makes any investing plan work is if it gives me the psychological confidence to stick with it. This will help me stick with options trading better than I could before, and will as well benefit my discussions with my asset manager who manages my retirement account. I’m seeing his recommendations to include noncorrelated assets in the portfolio in a whole different light now.
- I no longer pay for any of the higher end models for Gemini, Claude, and ChatGPT. And even when I did, all three of them were likely to say patently wrong things about options trading. I know what I’m doing so I can call them out on it, but I am careful with anything they suggest. ↩︎