How much did your hedges give back?

On a big rally week, the question I ask is how much my hedges gave back, and whether that’s about right.

If the hedges only gave back a small slice of what the long book picked up on a really big week, I’ve got no complaints there.

If they’re giving up a big chunk of what the longs made, then maybe the hedges are feeling a bit too heavy. Maybe there’s too much on, or the strikes are sitting too close, something like that.

Part of why it works is convexity. As the market rallies away, the deltas on the option hedges drop, so they cost you less the further it goes. That’s the whole point of having option hedges in a portfolio. A short futures hedge would keep costing you the same on every point up.

And I think it’s worth being honest about what the hedges are there for. Drawdowns are part of the game. The hedges are there to mitigate them a bit, maybe keep them a lot smaller than they otherwise would’ve been. The job is to cushion the blow. If you expect them to make drawdowns disappear, you’ll probably end up with hedges so heavy they eat every rally.

Mind you, after a big rally like the hedges are probably a bit too light now. The strikes are further away and the deltas are smaller, so they may need rolling.

It’s the flip side of what I wrote about the other day, waiting for the second leg down before taking hedges off. That’s the down week check. This is the up week one.

How I think about the weight of a hedge is something I make it part of my framework. It’s the risk management step, and it comes after regime, vol and structure. I also cover what “about right” might look like for your own book.

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