Using Dynamic Hedging to Protect a Brokerage Account with 10x Leverage and 38.49% Upside Over the Past 7 Days

I am trying to use LinkedIn as a personal log to memorialize extraordinary events for the public record. This is not investment advice - the strategies referred in this post were adapted and timed for market entry at the end of January 2020 and are not applicable at the time of posting.

I want to make the case for a change in mentality from retail investor to retail trader. It is a logical consequence for anyone following the public markets and willing to adapt their money strategies from a 10-year bull and low volatility market to the bearish and highly unpredictable environment we have been experiencing since February 2020.

I further posit that a successful stock operator has to focus on two main objectives to drive his strategy:

1. Capital preservation in a downturn market
2. Positive returns in line with the market trends and momentum

By capital preservation I mean the original investment, most likely as a lump sum given the leveraged position I am favoring, should not risk losses larger than 20% in the event of a forced liquidation.

Tracking market trends and momentum in the form of positive returns means if the market slumps 10% over a period of time (or gains 10% for that matter), the profit of the account should aim to be as close as possible to the absolute variation in the underlying basket of assets. Once again, my preferred instrument of expression are US publicly traded stocks and indexes, mostly for their high liquidity and easy access to derivatives.

Over the past 6 months I taught myself some dynamic hedging by connecting with people on social media, reaching out to people who traded successfully during the 2009 crisis and sifting through vast amounts of online materials, both paid and free.

In the end all that was left to do was setting up a practical hedging strategy in a live account - initially using the SP500 (SPX Index) options in late January and a few days later replicating a similar approach on Russell 2000 (RUT Index). The net liquidation value of the account at the time was roughly 150,000USD (45% up since first trading it in early September 2019 as a result of different strategies, among which the most successful was writing options for premium on technology stocks).

While the hedging trade design was meant to be always net credit (or only incur minimal cost), my own lack of patience made me accelerate the implementation at a cost of cca. 600USD for protecting the entire account. I considered the figure acceptable since it fit with the expected cost from deploying PUTs as account protection, as described by Nassim Taleb and Mark Spitznagel in their interviews about the tail-hedging strategy they employed to return huge gains to their investors during 2007-2008 (0.6% of principal for 4 months).

The account standing at the time of writing is reflected below - a portfolio margin setup with 67 positions (long and short stocks and derivatives). Current VAR around is 18,000USD, portfolio Beta 1.1, Sharpe 2.37 - it appears Interactive Brokers and the OCC like the setup as my margin requirements often change favorably in the morning.

Lessons learned:

1. Always trade hedged
2. You have to manage the hedge aka "dynamic"
3. There is no hedge against being wrong
4. All the information you need is out there, need to look for it and think on your own

Margin interest is among the least expensive loans available to a small business. Hedging can be used for more than protecting a portfolio against adverse market conditions - this very same process can be used to de-risk a company's entire revenue (and valuation, if derived from its operations and business continuity) with a small cost compared to the limited protection offered by business insurance or chasing an illusory revenue diversification strategy.

The highly leveraged position presented in this live account - using a net liquidation value of 160,000USD to control 1.736M gross exposure is probably enough to make retail traders feel uncomfortable and quick to put forward their opinions. This is why I included the Value-At-Risk, portfolio beta and Sharpe ratio - while not conclusive, they provide enough of a benchmark to put the level of risk baked in this portolio in the context of their past experience.

And because I used in the title of the article the 7-day return of this portfolio during the most tumultuous trading period since the 1987 market crisis, I have included below for reference the payoff curve for the SPX #meltdownhedge position alone (volatility-coordinated, for the payoff curve of the entire portfolio please see my LinkedIn timeline for updates).

While acknowledging I am a hack and barely know what I am doing, if I get any questions I will do my best to answer.

Thank you for reading so far and taking any time to share your thoughts and feedback.