Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

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Park
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Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Park » Wed Nov 29, 2017 1:02 pm

A general rule is that one should invest in stocks with at least a 5 year time horizon. But circumstances can change unexpectedly in one's personal life, such that at least temporarily, one doesn't want to be exposed to market risk. One could sell stocks, and that would remove the market risk, but at the possible cost of taxes.

Another way to deal with such a situation is to hedge out the market risk. From what I can see, short selling an index ETF or selling index futures would be two ways to do that. My question is which of the two ways is better? Since I have very limited experience with shorting and no experience with trading futures, I thought that I would ask this forum.

Index futures would likely have to be rolled every few months. That wouldn't be necessary with short selling an index ETF. So the time spent would likely be greater with futures.

Which would be cheaper? You'd have to roll the futures every few months, and that would cost money. But if you're using liquid index futures, the costs would likely be small. Because you might trade less with short selling an index ETF, transaction costs might be less. However, there would be the costs of shorting. For a liquid ETF (SPY for example), shorting costs would be low. My guess is that selling index futures would be cheaper, although the difference might not be great.

Which would be more tax efficient? There's greater ability to defer cap gains with index ETFs than futures. But since the market tends to go up, you might be looking more at cap losses than cap gains. Tax efficiency may not be that important.

When you short an index ETF, you'd have to pay the dividend. With futures, the dividend is already embedded in the price.

When you short, you have to use margin. You wouldn't have to use margin in selling index futures, but that might result in a larger portion of your portfolio allocated to this than you'd like. So you might use margin when selling index futures. Margin requirements would then be a consideration. Margin requirements for futures tend to be lower than for stocks, although with portfolio margin, the difference might not be great.

One's own familarity with short selling or futures trading might play a role in the choice made. Also, whether you can short stocks or trade futures in your present accounts would be a factor. Finally, in a tax advantaged account, you probably wouldn't be able to do either. You could buy an inverse ETF though, although that has problems of its own.

Comments?

avalpert
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by avalpert » Wed Nov 29, 2017 1:07 pm

Why wouldn't you start by reducing your exposure to market risk?

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randomizer
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by randomizer » Wed Nov 29, 2017 1:17 pm

Portfolio insurance hasn't really worked historically, as far as I can tell.

lack_ey
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by lack_ey » Wed Nov 29, 2017 1:24 pm

Shorting futures would be cheaper. There's a reason why that market is so large. One issue is that even one S&P 500 E-mini is a contract for $50 times the S&P 500 index level, so you're only able to sell in increments of about $131,000 now.

In a lot of platforms, rolling futures should be a simple operation, frequently doable in just one command.

I'm not familiar with the exact tax implications, though.

bgf
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by bgf » Wed Nov 29, 2017 1:26 pm

would buying out of the money puts also be an alternative for you?

you mention hedging, so depending on your horizon, what you are really looking for is decreased downside volatility in your overall portfolio, correct? in exchange for that, you would be willing to lose small amounts of money consistently over time.

Sounds like you could just continually purchase an appropriate amount of out of the money puts on the index. if they expire worthless, that is the price you paid. if the markets turn sharply downward, then the increase in the value of the puts will hedge the decrease in your overall portfolio.

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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by whodidntante » Wed Nov 29, 2017 1:27 pm

avalpert wrote:
Wed Nov 29, 2017 1:07 pm
Why wouldn't you start by reducing your exposure to market risk?
Taxes

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greg24
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by greg24 » Wed Nov 29, 2017 1:47 pm

For most people, derivatives increase risk, not reduce it.

bgf
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by bgf » Wed Nov 29, 2017 2:01 pm

greg24 wrote:
Wed Nov 29, 2017 1:47 pm
For most people, derivatives increase risk, not reduce it.
I think that depends on how they are used. A simple call/put option provides a certain and limited downside in exchange for an asymmetric upside. Depending on how you use them, they need not be very risky. I think there is a substantial difference between simple derivatives that have been traded since the 19th century and the kind of crazy complex derivatives that exploded in I guess the '70s and '80s.

long_gamma
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by long_gamma » Wed Nov 29, 2017 8:48 pm

Looks like you go thro' pro's and con's of your own question quite diligently.

One thing about shorting during time of stress is broker margin rates and some lending rates for ETF's increases much more than span margin requirements of futures.

Other good option is to use collars. With both skew and vol's are at the low end of the range. This would be my preferable strategy.

https://www.minneapolisfed.org/banking/mpd

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JBTX
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by JBTX » Wed Nov 29, 2017 9:56 pm

I can't see the logic of doing all these defensive measures for an individual investor. Seems like one would either want to be in, long term, or out. Modify your asset allocation according to your risk tolerance.

Seems like the tax complications surrounding a bunch of shorts/options, and futures would be just as much than consequence of selling stocks. But again, why are you selling stocks? Either you are in, or you aren't.

Problem with shorting stocks/market is in theory with shorts there are unlimited losses. The more the market goes up, the more you lose. Of course, your portfolio goes up, but then you have to sell some of your long positions to cover your shorts. That seems to be kind of pointless.

If you are long one way, and short another (whether will puts or futures or short positions) the positions are offsetting each other, and you have transaction costs, and potential tax impact. Again, why?

Also, depending on your investment portfolio, your hedge positions may not exactly mirror your long positions, and if no, you add risk there.

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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by nisiprius » Wed Nov 29, 2017 10:20 pm

I think that the risk premium is a reward for taking risk. I don't think there is an easy way to get the return of the stock market without actually taking the risk. If there were, everyone would use it, the stock market would not be risky, and the risk premium would vanish.

I don't really know what the pros do when they use "hedging" strategies. But my belief is that you can't eliminate the risk at no cost. What you can possibly do is to reshape the kind of risk you are taking--at a cost.

The question to be asked about any proposed "hedging" strategy is, given that it probably reduces both return and risk, is: how does it compare with simply cutting down your stock allocation?

To take a concrete example. Suppose you have an 80/20 allocation to Total Stock and Total Bond, and you want to reduce your risk. Let's compare two ways of doing it. PMethod number 1 is simply to cut back to 60/40. Method number 2 is to replace 7% of the stock allocation with a 2X inverse S&P 500 ETF to hedge the risk. Here are the comparative results.

Portfolio 1 (blue) 80% Total Stock, 20% Total Bond. Standard deviation 12.02%
Portfolio 2 (red) 60% Total Stock, 40% Total Bond. Standard deviation 8.98%.
Portfolio 3 (yellow) 73% Total Stock, 7% ProShares Ultrashort S&P 500, 20% Total Bond, 8.97%.

So, both cutting back stock allocation and hedging it succeeded in cutting the risk, by virtually the same amount.

But compare the actual return from doing it the simple, obvious way (red) and doing it the sophisticated way (yellow).

Source
Image

Now, you may say that an inverse ETF is not exactly what you had in mind as a way of hedging market risk. OK. But my point is that the comparison you must always make is not between doing nothing and hedging ("Look! It did cut the risk!). It is between cutting risk simply by reducing exposure to the risky asset, versus hedging.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

long_gamma
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by long_gamma » Wed Nov 29, 2017 10:49 pm

Comparing hedging to 10+ years of buy and hold is foolish.

Hedging is done for specific reasons and specific time frame. OP has mentioned his reasons that he needs an hedge (personal life circumstances and taxes) and time frame.

Park wrote:
Wed Nov 29, 2017 1:02 pm
A general rule is that one should invest in stocks with at least a 5 year time horizon. But circumstances can change unexpectedly in one's personal life, such that at least temporarily, one doesn't want to be exposed to market risk. One could sell stocks, and that would remove the market risk, but at the possible cost of taxes.
"Everyone has a plan 'till they get punched in the mouth." --Mike Tyson

lack_ey
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by lack_ey » Wed Nov 29, 2017 10:57 pm

The hedging here by shorting virtually the same thing as the asset is effectively like selling, without the tax cost of actually selling. It's not really an active strategy any more than actually selling would be, to respond to changes in risk that can be taken as a result of personal circumstances (need/ability/willingness to take risk). Not going for something special, some kind of alpha, or anything like that.

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whodidntante
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by whodidntante » Wed Nov 29, 2017 11:43 pm

If you want to be really lazy about it, or do it in a retirement account, you could buy and hold this ETF. Good luck trading it.
http://www.cambriafunds.com/tail

aqan
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by aqan » Wed Nov 29, 2017 11:47 pm

greg24 wrote:
Wed Nov 29, 2017 1:47 pm
For most people, derivatives increase risk, not reduce it.
Not true. its a zero sum game.. Buyers loss is sellers profit. so if it's increasing risk for one party it will be reducing for the other.

acanthurus
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by acanthurus » Thu Nov 30, 2017 1:17 am

nisiprius wrote:
Wed Nov 29, 2017 10:20 pm
Portfolio 1 (blue) 80% Total Stock, 20% Total Bond. Standard deviation 12.02%
Portfolio 2 (red) 60% Total Stock, 40% Total Bond. Standard deviation 8.98%.
Portfolio 3 (yellow) 73% Total Stock, 7% ProShares Ultrashort S&P 500, 20% Total Bond, 8.97%.
I realize it's difficult to back test this stuff, but I think looking at the CBOE PPUT index might be a better comparison.

https://www.cboe.com/publish/micropdf/C ... -Paper.pdf

They also have put write and buy write indexes with historical data for both returns and volatility, but I don't really consider those "hedging".

http://www.cboe.com/framed/pdfframed?co ... ed+Returns

Hedging has an advantage over traditional stock/bond portfolios in the case where stocks and bonds become correlated in a downturn.

lack_ey
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by lack_ey » Thu Nov 30, 2017 1:51 am

aqan wrote:
Wed Nov 29, 2017 11:47 pm
greg24 wrote:
Wed Nov 29, 2017 1:47 pm
For most people, derivatives increase risk, not reduce it.
Not true. its a zero sum game.. Buyers loss is sellers profit. so if it's increasing risk for one party it will be reducing for the other.
I think it could increase risk for both sides or decrease for both, depending on their other risk exposures.

If there's any volatility in an asset return, short that asset will have the same volatility. For sure if both sides just hold cash and one side is long and the other short some derivative like an option or futures like have been already discussed, that is increasing uncertainty for both sides.

msk
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by msk » Thu Nov 30, 2017 3:26 am

For a one year horizon I would go about removing risk a bit more simplistically. Let us take an example of a stake in SPY. SPY is trading at $262.6.
Buy one-year Puts on SPY at a Strike of $262, Cost $14.75
Sell one-year Calls on SPY at a Strike of $270, Collect $10.40

Total cost = $4.35, but you will collect a dividend of $4.78 over the next year, making your net cost zero AND you will benefit from any rise in SPY up from today's $262, up to $270. Downside risk is nil.

One can fine tune net cost vs upside potential. Greater cost, more upside.

Park
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Park » Thu Nov 30, 2017 10:10 am

Thanks to all who responded for the feedback.

I hadn't thought about options much. I have no experience with trading futures, and very little experience with shorting stocks; I have a little experience with options. Based on that, I thought a collar (buy a put for downside protection, sell a call to pay for the put, resulting in a hedge) would be more costly. But on a stock like SPY, it might not be. SPY may have the cheapest options of any stock, so I'm less certain about hedging nonUS stock market exposure using options.

Options also have the advantage that you don't have to worry about changes in margin requirements.

With options, your costs are somewhat fixed and known at the start. That's not true with shorting, and after 3 months, it's not true with futures.

With options, there is counterparty risk. With futures, that's also a risk, but probably less. There's no counterparty risk with shorting, but your stock might get recalled.

The use of a collar might also be the only way to implement a hedging strategy in some accounts.

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greg24
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by greg24 » Thu Nov 30, 2017 2:53 pm

aqan wrote:
Wed Nov 29, 2017 11:47 pm
greg24 wrote:
Wed Nov 29, 2017 1:47 pm
For most people, derivatives increase risk, not reduce it.
Not true. its a zero sum game.. Buyers loss is sellers profit. so if it's increasing risk for one party it will be reducing for the other.
That is what people would like to believe.

acanthurus
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by acanthurus » Thu Nov 30, 2017 3:41 pm

aqan wrote:
Wed Nov 29, 2017 11:47 pm
Not true. its a zero sum game.. Buyers loss is sellers profit. so if it's increasing risk for one party it will be reducing for the other.
The person selling you a derivative is usually a market maker that is going to hedge their new position immediately with other instruments. They make money on the bid/ask without assuming risk due to moves in the underlying. In aggregate across the entire options market sure it might be zero sum, but it's not true for any two given participants in a given transaction. Reading this thread there are some folks here that probably understand more than I do about this, so maybe they could elaborate on how this works.

Park
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Park » Wed Dec 06, 2017 1:11 am

When it comes to short selling an index ETF, the issue of "shorting against the box" ( short selling a security that you already own, which is not allowed) has to be considered. It may not be an issue, or you may have a way to get around it with a similar but different ETF, but it can't be ignored. When you hedge with options or futures, it's not an problem.

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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Swelfie » Wed Dec 06, 2017 2:21 am

In a tax advantaged account, sell a deep in the money covered call. Since it's covered it's fine in an IRA. This essentially takes you out of the market since every dollar lost in the call when you buy it back is covered by a gain in the stock. Plus you pocket the time value of the option so you are still earning. Risk in such a situation is pretty negligible, like investing in short term bonds by taking money off the table that could be in equities.

In taxable it's a different story. With options you are likely accruing capital gains in the stock but can't write off your losses in the option. One method is to sell deep in the money naked calls on a similar index. You may not have a similar index with enough option liquidity to get good prices though and there may be tracking error. You also need quite a bit more margin available. Risk is low still though and you get time value of the option.

Futures or SSFs are another method in taxable. These also suffers from liquidity problems because you will want to short a different but similar index. Time value is much lower, but so are margin requirements.

Getting even fancier, if the stocks are in tax advantaged you can sell naked calls on another index in taxable. Since markets tend to go up you not only get the time value of the option but also are likely to suffer short term capital losses to write off against gains now or in the future. You could use these losses to then actually sell off something in taxable and rebalance in tax advantaged to lower your exposure permanently at no tax cost. You run the risk of being stuck with short term capital gains though with no offset.
Last edited by Swelfie on Wed Dec 06, 2017 4:23 am, edited 1 time in total.

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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by JoMoney » Wed Dec 06, 2017 3:39 am

greg24 wrote:
Wed Nov 29, 2017 1:47 pm
For most people, derivatives increase risk, not reduce it.
It's a mixed bag. There certainly is additional risks with regard to things like counterparty risk and a completely different 'system' with regard to potential liquidity and systemic market-wide issues in the specific derivative market, and the time frame specific sensitivity element that is added to it.

There is a lot of 'naked' uncovered positions within the various derivative markets that are somewhat reliant on a liquid market. How that might unwind in some sort of unexpected disaster could be... well, disastrous...
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

Park
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Park » Wed Dec 06, 2017 12:32 pm

I implied upthread, that if you own an index ETF, and then effectively short the same index using futures or options, that you wouldn't be violating the shorting against the box rule.

Swelfie, who knows much more about this than me, implied that I'm wrong. I strongly suspect that I am.

Swelfie
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Swelfie » Wed Dec 06, 2017 1:23 pm

Park wrote:
Wed Dec 06, 2017 12:32 pm
I implied upthread, that if you own an index ETF, and then effectively short the same index using futures or options, that you wouldn't be violating the shorting against the box rule.

Swelfie, who knows much more about this than me, implied that I'm wrong. I strongly suspect that I am.
From my previous reading I think it is shorting against the box. But I have no idea where that reading comes from and can't site it, it just seems to be "something I think I know". It's never come up for me and I doubt it ever will personally. I only long/short like this in tax advantaged accounts on rebalance bands to steal that little extra time value of the option out, and in tax advantaged it doesn't matter.

Personally I don't see myself running into a situation where I need to secure my investment in taxable for a non permanent period since I don't market time. Maybe if my taxable were larger and I wanted to hedge against sequence of returns risks ramping up exposure over a period? But my tax advantaged are big enough to handle that so I'd rather just increase bonds if I went that route.

Park
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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by Park » Wed Dec 13, 2017 10:23 am

Thanks Swelfie for the post. The following is from Forbes Sept 2016:

https://www.forbes.com/sites/greatspecu ... ed8f78c00a

Shorting against the box is when you own a stock, and then short the same stock to hedge the position. This is a constructive sale, and the IRS doesn't allow this.

"The constructive sale rules apply on substantially identical properties, which includes equities, equity options (including put options), futures and other contracts. For example, Apple equity is substantially identical with Apple call and put equity options."

"Exception: A trader can still achieve tax deferral on an open short against the box position at year-end if he buys to cover the open short position by Jan. 30 and leaves the long position open throughout the 60-day period beginning on the date he closes the transaction — so there is an economic risk."

https://blog.wealthfront.com/hedging-stock/
https://www.wsj.com/articles/SB864392798127902500
https://www.thestreet.com/story/769361/ ... cerns.html

Puts and collars look like they are allowed.

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Re: Hedge Market Risk By Short Selling Index ETF Or Selling Index Futures?

Post by alex_686 » Wed Dec 13, 2017 10:35 am

Park wrote:
Wed Dec 13, 2017 10:23 am
Puts and collars look like they are allowed.
Maybe. Constructed sales cover a vast swath of transactions and the IRS has not bothered to closely define every transaction. In short, to be deemed not a construed sale the transaction must have a economic purpose, not just a mere tax purpose. If the put option is too in the money, if the collar is too tight, they might be deemed as a tax only transaction and trigger taxes.

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