Possible brainlet question bear with me. >Portfolio theory says you manage risk by buying an optimal portfolio and mixing it with risk-free investments >Optimize portfolio by maximizing returns at given risk >The more negatively correlated your assets the better your portfolio >Problem is most assets are positively correlated
BUT instead of doing all that, why wouldn't I just buy correlation swaps to directly hedge against correlation of exactly the assets I'm holding?
That way, I can hedge against correlated risk to the precise degree I like and I don't have to buy shitty government bonds with no returns.
So, let's assume I'm strongly risk-averse and would end up buying a larfe amount of risk-free bonds. Are you saying the opportunity costs would still be less than the price of the swaps to get the same risk level?
What if instead of buying swaps I sold call options on all the stocks in an ETF, then bought call options on the ETF? That way I'm also buying correlation and not paying a premium
Owen Walker
Generally if you see an obvious arbitrage opportunity like that it means there's some risk that you haven't accounted for.
Mason Thompson
What's the arbitrage? I'm obviously not making net profit if I'm buying and selling calls on the ETF and its constituent stocks in equal amounts. I'm just doing it to hedge against correlation, so I can buy the highest-return stocks without having to add in worse performers for the sake of diversification.
John Diaz
I don't understand are you talking about, this doesn't sound like biz
Selling call options? Are you implying that you would actually write options? or did you perhaps mean to say you'd sell puts on all the stocks in an ETF? Come to think of it, this may actually be a pretty neat idea. Buying calls on an ETF, then buying puts on each stock at an equal amount you could perhaps ensure a profit? As not every stock within the ETF will go up, buy the ETF itself will most likely go up...
Ryder Gonzalez
kek
Aiden Adams
Yes sorry I mean buying puts on the stocks and calls on the ETF, not even necessarily to make profit (although I guess it could be profitable?) but also to buy correlation so I can hold the same stocks myself in greater amounts instead of buying worse stocks just for the negative correlation so I'm diversified.
I've read fooled by randomness, black swan and antifragile. I'm well aware of fat-tails and so-called 10-sigma events. I'm also aware of LTCMs hedging strategy using similar tactics by targeting inefficiencies and leveraging to the hilt.
Eli Sanders
Wait are you talking about a microcosm where you employ portfolio insurance (options to provide 'floor' for your stock) and a macrocosm where you also purchase an ETF that holds that stock and many more besides it? I'm starting to get confused user
>That way, I can hedge against correlated risk to the precise degree I like and I don't have to buy shitty government bonds with no returns.
there's plenty of fixed income investments that yeild 5%+ look into preferred shares and closed end funds.
Brayden Perry
Okay, let me make myself more clear. According to CAPM, there exists a (theoretical) optimal portfolio (market portfolio) which has the highest returns at a given risk level and the correct way to manage risk is to buy he market portfolio and reduce risk with an arbitrarily large risk-free position. Of course, this isn't realistic so in practice you just try to approximate an efficient portfolio by diversifying. Let's say I have two hgh-performing, but highly-correlated stocks, AMZ and APL. Let's assume NNND is negatively correlated with both of those. According to portfolio theory, holding NNND is preferable to going all-in on APL and AMZ, because I'm reducing risk more than returns.
However, what if instead of holding NNND, I buy a specific number of call options on a theoretical ETF that only consists of APL and AMZ. Meanwhile I buy put options on APL and AMZ (yes, the same stocks I'm holding). The money I have in these options is the same I would've otherwise used to diversify my portfolio with NNND.
I'm now directly invested in the correlation between APL and AMZ, so I can hold both of those stocks and adjust my money in options to reduce correlation-related risk arbitrarily.
My question is: Does the options trade cost me more than the opportunity cost associated with buying the underperforming NNND stock for the sole purpose of diversification? Because I believe that it wouldn't.
Caleb Collins
This hinges on the theory that you will be able to >adjust my money in options to reduce correlation-related risk arbitrarily Seems like an awful lot of work. To make this work I'm guessing you'd have to buy AMZ and APL puts to lock in the spread while hoping your ETF calls appreciate? Depending on how you tweak it I guess you could remove risk, but it would take a lot of work. Regarding opportunity cost you would probably make less profit, but could substantially reduce risk. Forgive me if I'm a bit out of my depth here.
Alexander Morales
>I'm now directly invested in the correlation between APL and AMZ How so?
Alexander Gomez
Yeah I'm not sure how much work/broker fees/regulations would factor in here, more of a theoretical question.
Basically I'm wondering why the general theory is that diversification is the optimal way to reduce risk when negative beta assets are generally rare and perform badly and when it's possible to directly offset any correlation between my assets using methods such as the one I described.
Jacob Gutierrez
What you’re describing sounds like active hedging, which is very difficult to do accurately and takes a ludicrous amount of time and unless you have billions of dollars to throw at the problem (like LTCM before their crash) the money you’re liable to make just isn’t worth it. Your profit on either of our options position will only be high if there’s a major market event- even the volatility of the past few weeks probably wouldn’t pay off in a significant way, but I could be wrong.
Christian Bailey
Because the lower the correlation between the stocks, the more will a portfolio of individual call options outperform a call on the ETF or index containing those stocks, and I'm betting the opposite.
Brody Jenkins
But I'm not looking to make my money off the options trade, I'm just using the options to reduce risk on my profitable (but undiversified) portfolio. So if APL and AMZ behave normally and both go up, I'm fine. But if they both reverse and tank, I'm also fine because in that case my options will actually become profitable (still a net loss of course, anything else would be arbitrage, but a calculable and adjustable risk).
Kevin Peterson
>why the general theory is that diversification is the optimal way to reduce risk Because almost everything you can think of has hidden complexities and has most likely been been the cause of major blowups before. Either that or there just isn't any profit to be made after all expenses are accounted for. In your case, probably both. Theoretically, if the market outlook is bullish, and you come across some inefficiencies where you can 'lock in' some spread, then I guess it could work wonders. However, too many moving parts and the results being contingent on too many factors poke holes in this theory.
