AI-Assisted Hedging Strategies: Part 3

Effective hedging strategies are a key objective for long-term investors in portfolio management. Unlocking the potential of options can be a powerful tool to enhance long-term investment strategies significantly.

Continuing our hedging mini-series, we explore an alternative mechanical approach that builds on the well-known collar strategy, also for the core portfolio of SPY. Backtesting these strategies requires our calculation engine to track option positions and P&Ls accurately. As an initial exercise, we constructed a portfolio that essentially replicates the Innovator U.S. Equity Power Buffer ETF – October (POCT). On October 1, 2023, we hedge SPY with short 15% OTM calls, long ATM puts, and short 15% OTM puts, all with one year to expiration. Below, we compare the NAV of this portfolio named ‘SPY w/ Yearly Buffer’ to POCT, which tracks very closely.

Next, we explore a similar strategy, with the main difference being a shorter options expiration period, shifting from annual to quarterly, and adjusting the strike levels. At the start of each quarter, we initiate short 5% out-of-the-money (OTM) calls and long 1% OTM puts, while capping the downside protection at 20% OTM. These positions are rolled over at the end of each three-month period, with the number of contracts designed to hedge 100% of the underlying SPY. In the chart below, we present the NAV curve of the strategy titled ‘SPY w/ 5-1-20’ over the past three years.

Finally, we compare the portfolio of SPY w/ 5-1-20 to a standard large-cap core portfolio, represented by SPDR S&P 500 ETF Trust (SPY). The backtested NAV curves for SPY w/ 5-1-20 versus SPY over the past three years, are as follows:

In the following table, we display some key performance measures for the two portfolios. Adding options can reduce risks, especially in terms of max drawdown, while maintaining comparable returns for this period.

In conclusion, systematic and disciplined hedging strategies can be built on OdinUltra using complex logic to improve risk-return characteristics. Users can quickly generate detailed backtest results and may further improve these results with multiple hedging strategies using OdinUltra, which empowers asset managers to leverage their domain expertise throughout the entire investment process to explore, construct, verify, and deploy investment ideas and theses quickly. 

To learn more, contact us at strategy@odinultra.ai.