The last presentation of the day today at CBOE’s Risk Management Conference also turned out to be one of the best. Boris Lerner, Head of US Quantitative and Derivative Strategies at Morgan Stanley and Arie Aboulafia, Senior Portfolio Manager from Capstone Investment Advisors teamed up to discuss “The Art of Hedging”. Many market participants have forgotten that there is a non-quantitative aspect to investing and trading since the industry has become so quantitative. This session at RMC was an excellent reminder that investing and trading is just as much an art as a science. Paul Stephens from CBOE joined them on the podium and asked questions during the presentation.
The session began by Arie breaking out portfolio risk into two familiar subcategories – event risk and tail risk. Event risk is associated with events that will normally have a defined time horizon along with a catalyst. Tail risk, which is the one that gets the most attention as these risks may results in more dramatic market moves, are those rare events that are difficult to measure or time. He also defines a tail risk event as one that results in a portfolio moving more than 3 standard deviations from current levels.
When deciding what hedge should be implemented a portfolio manager needs to define the type of risk. Then they need to use a fundamental outlook to decide the best strategy. If no strong fundamental view exists the portfolio manager may then defer to what the market is pricing in at the current time to determine the approach for hedging.
Approaches using both S&P 500 Index options and volatility oriented derivatives were discussed as hedging alternatives. The presentation finished up noting that SPX at-the-money volatility is back at low levels, but SPX skew reflecting higher risk premiums. Finally it was noted that equity implied volatility is fairly low relative to other classes while interest rate and commodity volatilities are relatively expensive.
What should be the maturity of the hedge and the structure? Buy put or put spread collar? Delta less important than one would think. Put spread collar best hedge over the last 12 years, mainly because it’s cheap. Put spread collar makes sense in high volatility environment, but did surprisingly well in low volatility market.
Selecting expiries and strikes, one-month did best. Long-term – rolling early can reduce cost. Short-dated OTM strike SPX puts seem to underperform.
“VIX Futures trades like water”, can structure different strategies using VIX options. Arie likes using VIX calls or SPX put spreads, but it’s obviously based on each customers objective.
Boris and Arie looked at “If S&P is down X%, where should VIX be”? For example, if you thought SPX had a 20% chance of a 10% move lower, what VIX strategy would show the same probability? Very interesting comparison.
SPX ATM Vol is back to lows while Skew reflects higher risk premium. SPX put spreads look attractive now as a hedge against moderate US equity pull backs (10% to 15%).
In answer to a question, Boris said they measure whether dealers are long VIX exposure or short using futures and option data. Currently fairly neutral.