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FT Portfolio with Dynamic Hedging

October 15, 2009

Ok here is a quickie post to show the risk reduction benefits of dynamic hedging. In this case we are using a long/short portfolio that does not need to be market neutral. If the S&P500 is above the 200ma we will go net long 25%, and if the long portfolio is above its 2 period EMA (2 weeks)  then we will go net long 50%. The remainder of the portfolio is of course fully hedged against the bottom 20 FT. Should the S&P500 drop below its 200 ma and the long portfolio is below its 2 period EMA, we will be fully market neutral.  Essentially we are leveraging our long exposure only when it is least risky to do so—-ie its a bull market, and our portfolio is rising. This isn’t the optimal method and there are many possible combinations, but the results are superb on a risk adjusted basis. Max drawdown for the Dynamic portfolio is only -12%,  and both the Sharpe and DVR are very high. This is more comparable to what a hedge fund would require in risk/return characteristics. However, keep in mind that the portfolio does not factor in transaction costs, and with weekly rebalancing, this will reduce returns.

FTLongShortDH

4 Comments leave one →
  1. Rick permalink
    October 15, 2009 2:41 pm

    I’m not quite up to speed with your lingo yet. What does FT DVR stand for?

    • david varadi permalink*
      October 15, 2009 2:51 pm

      hi rick the DVR is the Sharpe Ratio times the R-squared of the equity curve. it is a standardized measure of the reward vs risk and the smoothness of the equity curve. This makes it easier to compare strategies accurately without having to rely on visualizing using a chart (which can be biased or incorrect)
      cheers
      dv

  2. Red Hue permalink
    October 16, 2009 12:06 am

    David,

    I am sorta dumb on hedging methods…can you explain in a “hedging for dumbies” manner what this means…or maybe an example using ETF’s or Mutual Funds?

    “The remainder of the portfolio is of course fully hedged against the bottom 20 FT. Should the S&P500 drop below its 200 ma and the long portfolio is below its 2 period EMA, we will be fully market neutral. ”

    Thanks much…your site is quite educational and interesting!

    • david varadi permalink*
      October 16, 2009 12:26 am

      thanks red…….hedging simply means that if we buy a position in something (mutual fund, ETF, or stock) then we will offset our market risk by shorting an equal position in something else: that is if we bet that something will go up, we simultaneously bet that something will go down. Our net bet now is not that something will just go up, but rather it will go up relative to something else. A full hedge, or market neutral hedge means that we have a 100% long bet and a -100%short bet at the same time, so our net exposure is zero. In this example we have 50% long 50% short and will add up to 50% extra……to be 50% net long if conditions warrant.
      cheers dv

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