Sunday, January 17, 2010

Portfolio X-Ray: Keeping Dubble Out of Trouble

One of my favorite aspects of blogging is all the wonderful people I meet through the Market Rewind chat-room.  One of our long-time members goes by the on-line moniker "Dubble",  or "Dub", as we call him.

Dub has been diligently working on building his trading skills and has come a very long way in a very short period of time, more recently focusing on Dow futures. One day not long ago, I received an email from a fellow trader informing me that our Dub is none other than acclaimed blues man, David Duncan [link fixed].  In fact, Dave just recently cut a couple tracks with BB King -- check it out!

This post is about Dub's holdings coming into the late-week sell-off.  We had been discussing how the market was becoming increasingly choppy and possibly overbought in the chat-room, and Dub graciously volunteered his portfolio as an example to illustrate basic hedging principals -- Thanks Dub!

Dub sent me a short list of his current holdings, including:  AGU, CF, POT, CNX, MEE, PCX, CLF, WATG, CYD and DWA.  Step One was to get a handle on exactly what these were.  Loading them into ETF Rewind's Exposure Tab, it was easy to see he was playing heavily in the Basic Materials sector.

In fact, the built-in returns matching algorithm perfectly nailed his exposure.  While this mix was relatively simple, you can see in the graphic below where the algorithms attempted to best replicate the portfolio's daily return characteristics (light blue = input), with a mix of popular ETFs organized by Asset Class and Sector (light orange = output):

The main aspect I want to focus on here, is how this virtual X-Ray turned me onto Dub's game.  As shown in the red circle, this portfolio is quite leveraged from a beta standpoint.  Well, not a bad play for a bull market.

However, what to do in light of an anticipated downdraft?  In this case, if Dub had hedged his portfolio using shorts or puts in either the selected mix of ETFs, or even the SPY at the indicated 1.65 times portfolio dollar exposure, he could have significantly reduced his risk without being forced to default to cash.  Here was the actual performance of the portfolio last Friday:

The average loss for the portfolio was -2.5%.  However, using hedges he may have reduced losses to -0.65% (-2.50% - (SPY -1.12% x 1.65)(frictionless).  Not perfect by any means, but not the stiff hit it would have otherwise been.  And hey, peace of mind is important in trading, not to mention understanding potentially hidden risks like this portfolio's beta exposure.  Furthermore, for more complex portfolios, (and perhaps especially for algorithmic traders  who may not always know what all of their individual holdings actually are at all times), you can see how important a tool like this becomes.

So Dubble -- did you manage to stay out of trouble last Friday?  I have no doubt that you did!


Kenneth said...

Good job dd-man, it's great to see your work posted online and I look forward to hearing more about your strategies. Congrats on the BB King gigs and my best to you on your new release.


michael168 said...

Very nice and informative post on hedging. Great weekend reading.