Hedge Ratio

Ok, simply put: it’s the ratio or percent of the total that you’re hedging...or protecting, in a bad market.

So let’s go through the market numbers we’re going to totally and completely make up. But they're reflective, anyway.

We’re gonna start with the notion that our entire portfolio at the moment is one security: ticker SPY, which more or less represents the S&P 500. That ticker trades today at $300 per unit.

We’re running a hedge fund, and our investors expect us to protect their investments in good and bad markets. So the question: how much are we willing to pay for that portfolio life insurance? How far down are we okay letting this $300 per unit index fund fall before we...protect?

Well, pricing matters, right?

So if we want to protect it for 3 months, such that even one dollar below $300 our hedges kick in, then that’ll cost a fortune. Something like $20 a share. Huge premium, which, if the index unit stays flat at 300 bucks for the next 3 months and change, then we’ve lost 20/300, or about 7% of our portfolio’s value. Very expensive.

What if we're okay with it falling to 280, but then protecting it below 280? Well, the pricing there to buy put options with a strike of 280, which expire in 3-ish months? Those cost $8 a share. Still expensive but…digestible. Maybe. Depends how nervous we are.

If we look at the 260s, then they only cost $2 per unit to fully hedge 100 percent of our portfolio. Less than 1 percent. And yes, we’re vastly generalizing the numbers here in order to present clarity.

As it relates to the notion of a hedge ratio though, the bigger question revolves around that 100 percent figure. That is, do we need to hedge all of our portfolio?

What if we're okay with 20 percent of it being 100 percent exposed to the market, or 0 percent hedged? If we’re paying $20 a unit to hedge at a $300 strike, then only hedging 80% gets a tad more digestible. Or...what if we only cared about hedging 50 percent of it, so half is floating and half is hedged?

There’s a whole bunch of math behind these numbers, and obviously none of it exists in a vacuum without logic behind it, but it’s this percent-of-portfolio-we-care-about-hedge that comprises the notion of a hedge ratio.

How much of our total investment universe do we want to protect? How much are we willing to pay for that protection? And as always, the right answer?

Yeah...cue the adult diaper company:

It Depends.

On what? Well, on how nervous nelly our investors are. Like, how much do we really care about the volatility of our portfolio? Think about the S&P 500 for the last century and change. Yes, it went…up. But it was hugely volatile.

Do we really care? If all we looked at was the price in 1920 and then the price in 2020, well, it went up a ton. Protecting the volatility was just a waste of money. Like buying a month of term life insurance in a month when you didn’t die.

So if we don’t care, then maybe the hedge ratio oughta be nothing. Over time, hedging is a bad bet if the market generally goes up most years and, over time, the market is up, something like 6 out of 7 years or thereabouts.

Do you really want to bet against that system? Against the modern math of capitalism? Probably not.

So the next “It Depends” question: how much do the hedges cost?

That is, if you could buy a million dollar term life insurance policy for 10 bucks a month...eh, even if you had nobody on Earth you really cared about leaving money to, but maybe if you got whacked by the 2:30 Midtown bus, you’d want to leave a professorial chair to your alma mater, then maybe you’d spend the 10 bucks a month on that term life insurance hedge.

But if it was a few grand a month, then...maybe not.

So hedge ratios kind of live in the land of “It Depends”...whether you want them at all, what percentage of your portfolio you want to protect, and how much that portfolio insurance actually costs.

Like the other “Depends,” it’s all about protecting yourself from...unforeseen accidents.