I'm interested in the perspective of those who short/hedge about suggestions they can offer in terms of improving risk-adjusted returns.
For context, I have a short model (more accurately, a screen of screens) with excellent 1-year results, i.e., >55% annualized returns. I've been using it out of sample (ie, real $$) for the last few years and the results have matched the backtests. However the path is extremely volatile, with drawdowns that occasionally exceed 40%. And those drawdowns can occur while the uncorrelated long strategies also suffer drawdowns, which is tough to endure. Consequently I find myself keeping position sizing small and relying on some other strategies to hedge risk. But if invested capital is too small it begs the question, "what's the point"?
I've considered an alternative strategy of buying puts, but in many cases there is little/no volume and unattractive pricing, to say nothing of the price decay I'll encounter when going long options. However I seem to recall that Yuval had some success via hedging with puts, so maybe there's a way to do this that I've overlooked.
I hedge with puts. I try to keep my puts at about 7.5% of my portfolio, buying or selling when the percentage gets out of whack. There's always a major bleed in premiums, and during bull markets the put performance is horrible. But it serves me well during downturns, and that's what a hedge is for. I think it's one of the main reasons my hedge fund did really well in the first quarter of 2025, significantly outperforming all my other accounts. And that makes a huge difference in overall returns, especially if you're using leverage.
The overall result of your short model, though, is far far better than the overall result of my put hedge! I'd love to hear more about it.
Thanks Yuval. I assume your puts are in highly liquid stocks (or ETFs), possibly with market caps >$2B? Or are you able to find these with small caps? If so that's terrific, I haven't such luck, at least not among the short candidates that I come across.
My short strategy is really a composite of multiple strategies. Typically I'm finding the best opportunities among those with nosebleed valuations + signs of momentum exhaustion, though that can be dangerous territory if you don't identify other signals that can mark a top or near recent peak. I've found some good signals that have boosted returns and reduced drawdowns somewhat, but the drawdowns are still challenging, especially if my longs (partial value tilt) are also in a drawdown, and therefore I limit this short strategy to ~ 10% all in. I'd like to take on bigger positions but I feel I need to reduce these drawdowns before doing so.
Furthermore there can be periods where there are few if any short candidates, so I just rely on my longs or hedging via selling calls on the indices, basically a modified covered call strategy.
I welcome any other thoughts you have on how I might improve this strategy. Thanks again.
P.S. Addendum - Re: puts, another reason I've avoided them is that, when I do find put pricing with reasonable volume, it's rare to find instances where implied volatility < historical volatility, and I believe I read a comment from you (Yuval) that that is one of your criteria. I have no doubt that it's very helpful, just wonder if it's essential with my strategy, ie is the real question whether puts offer a better risk reward than shorts and given the high return potential I should just move my strategy to puts where possible?
Something that might help your drawdowns on the short side is diversifying the nature of your shorts. Shorting a high flyer like say palantir can come with large drawdowns wereas something like a jc Penney short I did back in the day was less jumpy to the upside.
True, high flyers tend to crash quickly when and if the time comes, but the ultimate compound rate will depend in great part on your drawdowns. There is a non-trivial chance adding a few “stable” shorts could increase returns but of course you would know that best after some testing- maybe via a book that combines the approaches trying a couple different percentages. Sounds like you are doing great so far and looking forward to hearing an update sometime in the future.
My puts range in market cap from $200M to $10B; 15 out of the 23 stocks I have puts on are small caps (under $2B).
Yes, that's right, but I'm a bit flexible about it: for less volatile stocks I'm willing to bend a bit. I also use GTC orders so I'll often place a limit order at a price where the IV < the HV but if the underlying goes up in price a couple days later I'll pick up the put, which has gotten cheaper. In that case the IV won't necessarily be less than the HV at the time I purchase it.
That's a question I can't answer. I decided to use puts rather than shorts for reasons I outlined here: How to Profitably Hedge with Put Options - Portfolio123 Blog. But I still have my doubts as to whether a put-based hedge or a short-based hedge would be a better option. Given our respective out-of-sample track records, you're winning the game.
And thanks for telling us more about your shorting strategy. It sounds good!
I started my career as an options trader. There is all kinds of things you can do with options like put spreads, diagonal spreads, backspreads, etc. it is hard to backtest it but these can work when options are pricey. They often limit your upside but size can always be adjusted to account for that.
Thanks Yuval. Very helpful. And I appreciate the kind words but I suspect on a risk-adjusted basis that you have a better strategy via puts and it's time I adjust my approach accordingly.
One final question after reading your blog post on put options - in one part of the blog you indicate that all in, your puts have made ~ 31% on average, but in the final paragraph you state that overall you've lost 3% of your investment in puts. Was that 3% referring to your temporary drawdown of those active puts at the time of writing that blog post, or the overall results from inception?
Thanks again.
My put option strategies all failed and ended up costing me a lot of money. Maybe I lacked the necessary patience, but for now, I'm using TZA along with Hemmerling’s low-correlation ETF strategy as a hedge—mainly because it's something I could actually backtest.
As mm123 already mentioned, there can be periods where both short and long strategies experience drawdowns at the same time, which is especially painful when using leverage.
We really need a reliable way to backtest option strategies.
It's the difference between an arithmetic average and a compounded result. For example, if you only invested in one put at a time and you got returns of 142%, -55%, 142%, -55%, and -19%, you'd have an average gain of 31% and a total loss of 4%. The 3% refers to the overall results from inception.
Understood, thanks. What's interesting is that even with this small loss it sounds like you believe the puts have helped, which I assume is because they've provided enough benefit during market drawdowns that they've protected capital and/or allowed you to use some leverage. If so, it makes perfect sense.
Options shouldn’t be used to hedge stocks unless you can’t replicate the position using the underlying asset directly. That exception usually comes down to issues like liquidity, cost, or structural advantages that dealers have due to legal and tech infrastructure. In that case, they’re charging you for access to something you otherwise can’t get.
Now, if you have a view on implied vs. future realized volatility, or you believe the distribution of future returns is skewed in a specific way, trading options might make sense. But forecasting that edge is extremely difficult with the tools available here. And you’d be competing against the best: Jane Street, SIG, Citadel, and others who dominate that space.
What I am focused on at the moment is building tools that help with position sizing and portfolio construction, including: Volatility targeting (several methodologies), Long/short rebalancing to achieve symmetry (e.g., equal volatility weights on both sides), and risk parity with equal absolute risk contributions
When it comes to shorting, what’s helped the most is running a balanced long/short portfolio, where the selections on each side are designed to offset one another, not just bet on edge. I hope (and kinda suspect) the coming risk model will help with this.
As always: many ways to skin the cat.
TL:DR Hedge like asset with like asset, unless there’s no other way.
korr123 raises some very good points. If the longs & shorts aren't balanced it could spell trouble, and I think Yuval has developed some skill with options that can only be replicated with detailed, thoughtful analysis, if at all.
You may be right. But short positions are not symmetrical to long positions. You can make 1000% on a long position but your upside on a short position is limited to about 95%. You can't lose more than 100% on a long position but you can easily lose 500% or 1000% on a short position. That, to me, is not hedging "like asset with like asset." It's not like hedging currency risk with futures: in that case, the hedge is perfect. Hedging with shorts, on the other hand, seems fundamentally imbalanced. The advantage of working with puts is that the returns on a put position mirror the returns on a long position in that the possible loss is limited to 100% and the possible return can be huge. The major difference is the premium, which is 0 for longs and quite sizable for puts. You're right that you can't backtest this on Portfolio123. But what you say about competing against the best goes equally for long-short equity strategies. And Jane Street and Citadel don't hedge their equities with put options.
"The advantage of working with puts is that the returns on a put position mirror the returns on a long position in that the possible loss is limited to 100% and the possible return can be huge."
Put call parity would suggest buying call is equivalent in most cases for this positions (buy put, buy stock). Have you looked into this?
"But what you say about competing against the best goes equally for long-short equity strategies. And Jane Street and Citadel don't hedge their equities with put options."
It's true those guys don't typically hedge stock with options (only options with stock). But that's not because they haven't looked at this and missed the opportunity.
Long short has the better possibility of edge. You kinda know this because you focus on small caps precisely for this reason, I think.
Buy yeah, having a view on the distribution of the stock returns different from the dealers can be quite profitable.
I realized I kinda when off topic with my PSA about not trading options unless you have a view on volatility. Going back to the original post, I've dealt with this via diversification though I think that's sub optimal.
What you’ve tried makes sense—hedging your long positions that are working but carry too much risk. And as Korr points out, there’s more than one valid approach; he outlines several.
What I’d add is this: have you considered finding a hedge for your short strategy, rather than just hedging your longs?
Most people don’t take that route because it’s genuinely hard to find a short strategy that consistently works. But you already have one—which puts you in a unique position.
That raises an important question: can you reduce the volatility of your short model by partially offsetting it with a long portfolio that has a positive expected return but negative correlation with your shorts?
The typical logic behind hedging longs assumes that long alpha is easier to generate than short alpha. But in your case, the reverse may be true.
You could start with your short model and explore different ways to hedge it. One advantage of this approach is that long equity positions are naturally biased toward positive returns—so a long hedge may be more stable and easier to construct than a short hedge.
ETF of Gold can help you,maybe don t to cover like a hegde, but at less to reduce volatility and std deviation in a natural way and through diversification of assets. You can simulate it in books strategy
