Thread by @dampedspring

Hedging 101
Tl;dr
-Diversify
-If that doesn't suit you use options passively
-If you think you can actively hedge at the right time then you have alpha (you probably don't)
-If you hedge during an event you are better off dumping your portfolio cuz your already dead

Hedging a portfolio is a reasonable idea. It is designed to limit downside at the expense of upside. It is a natural desire to make sure your portfolio has a worst case outcome. It lets you "sleep at night" However how and when one hedge has big impact on long term return.

The first point I would like to make is that assets have a risk premium which provides long term excess return over cash. Investing in assets is essentially the only free lunch in markets. When you hedge you are eliminating some of the risk of your portfolio

The hedge provider takes on that risk and is paid some or potentially all of your risk premium.

The best way to have your free lunch and eat it too. Is to have a portfolio that performs well in all environments. The best way to harvest risk premium while minimizing risk is through the magic of diversification. At Bridgewater they called that portfolio All Weather

60/40 is a classic option. Harold Browne called his the Permanent Porfolio. Others call it risk parity. Choosing any of these is the best way to "Hedge" your portfolio. It costs nothing and reduces your risk

But this thread is about hedging. "Andy should I buy puts today?" I see how investing in assets with a systematic put purchasing program makes sense. It has costs but creating a less sloped hockey stick pattern to your investment portfolio outcomes is reasonable

If you want such a payoff pattern plan ahead and passively buy puts over some regular schedule. I think for most investors that means 6 month options rolled quarterly. I would time your portfolio rebalances and tax planning for that day and do it regardless of what's happening.

Passively hedging will minimize the cost through time and maintain your desired future return profile of you portfolio however it will come at a cost. Put options and for that matter any volatility product have a negative expected return vs cash because the buyer transfers

Risk from himself to the seller. That means that when you buy puts you transfer some of the free money of risk premium collection to the seller. It is critical to recognize that downside protection comes at a meaningful cost. OTM puts trade at a massive premium to OTM calls

The reasons for skew are many (good thread topic) but one is most certainly the fact that equities have a large risk premium and a lot of the perceived risk in an equity investment is drawdown risk and supply and demand reflects the need for people to "hedge"

So given skew my work has shown that a passive purchasing of put options eliminates a significant portion of the risk premium collected from holding equities. A passive portfolio of equities and a put purchase strategy does out perform cash and so some risk premium remains

But it's not much. I for one prefer the portfolio diversification method vs the put program. But wait. "Andy, what if I time the put purchases". Well if you can time put purchase and offset or eliminate the cost, you have alpha! Congratulations. You win the game of investing.

Two things. 1. What is your alpha? Is it the skill of predicting both delta and IV in a way that results in using put options to express the alpha optimally? Or is it market timing levels of the equity market. Or is it volatility forecasting. Make sure you know because that

Can guide what you do. If you have no alpha in vol. but a ton in price don't bother with options just lighten your equity exposure with low transaction cost linear product.

2. Do you actually have alpha. My guess is you don't. It's super hard and you will likely pay out transaction costs and have a negative expected return from your market timing activities particularly if you use high transaction cost product like OTM options

Lastly. Never ever hedge using options during an event. Transaction cost rise dramatically. If you buy puts when others are being forced to buy puts you are in for a bad experience. Plan ahead. Don't have a portfolio that forces you to hedge.

Perhaps you believe that purchasing puts during an event is a good idea because events last longer or this one is differ my or whatever. That's alpha! You probably don't have alpha. During such events the sharks smell blood. If you are trading it's probably yours. Ken, Thomas

and Jeff are Billionaires for a reason. If you don't know who Ken, Thomas, and Jeff are, you definitely don't have alpha! If you feel like you must reduce risk into a panic you haven't planned ahead. Perhaps you should take your portfolio to cash

It's a cheap means of risk management at that time when options are super high cost to trade and it would allow you to rethink how you invest. I hope this doesn't happen to you and you.

Plan ahead
Diversify
Invest passively including possibly a passive put purchase program
Know with certainty whether you have alpha (you don't)
By doing these things you can avoid diving into shark infested waters.