There is a good chance that we may be in for some more volatility, at least for the next few months. If so, then the Long/Long Hedge, which consists of rank 1 call and rank 1 put purchases, promises to be a good bet. This week we review the performance of this hedge and present a sample of this hedge as a portfolio consisting of about $10,000 in call and put buys.
Our Market-Neutral Hedges
Our market-neutral hedges are designed to take advantage of Value Line’s ability to differentiate between strong and weak stocks (through our common stock ranking system) and of our option model’s ability to pick favorably priced options. The Long/Long Hedge buys rank 1 calls and rank 1 puts.
Over the years, this hedge has shown robust performance, which is especially attractive considering its low exposure to the direction of the stock market. In Graph 1 below, we compare the performance of the Long/Long Hedge with that of the S&P 500. Over the seven and a half year period shown in the graph, the Hedge has been profitable 59% of the time, while the S&P 500 has gained only 52% of the time. In the 207 weeks in which the S&P 500 showed gains, the Hedge was profitable 67% of the time, while in the 189 weeks that the S&P showed losses, the Hedge showed gains 52% of the time.
In 2008, when the S&P declined by 35.9%, the Hedge showed a gain of 193.4%. The Hedge also showed strong gains in the first part of 2009, but more recently in the market rally, the rank 5 stocks have been strongly outperforming the rank 1s. This reverse rankorder performance has caused the Long/Long Hedge to give up about 10% of its gains since mid-March. However, we believe that in the current, more cautious, market environment, the common ranks and the Long/Long Hedge will once again start to show positive performance.
Building a Long/Long Hedge
We calculate the performance of our Long/Long Hedge from the average gains and losses of all our rank 1 calls and puts. Since there are thousands of different rank 1 calls and puts on any given day, it is virtually impossible to reproduce the exact results of the Hedge. However, we believe that a diversified portfolio of at least 20 rank 1 call and rank 1 put positions (approximately 10 on each side) can produce substantial gains, especially when there are broad swings in the market.
In Figure 1 below, we have constructed such a sample hedge, choosing 10 rank 1 calls and 10 rank 1 puts that are reasonably close-to-the-money and that expire in August 2009 or later. The positions range in value from $380 to $660. As constructed, the Hedge has spent a total of $9,966 in premium, $4.925 for calls and $5,041 for puts. Because of the spreads between the bid and ask prices, the entire portfolio shows a start-up loss of $759.
All the calls have a rank 1 for call buying and most of them are based on rank 1 stocks (i.e. stocks that are expected to outperform the market). All of the puts are rank 1 for put buying and most of these puts are based on rank 5 or rank 4 stocks (i.e. stocks that are expected to underperform the market).
To search for options, we used our Option Screener to screen for rank 1 calls and puts that were close-to-the-money and that expired in August or later. We used PortfolioTemplate.Xls to determine the size of the option position. A copy of this template with the current hedge positions is available upon request.