Comparing SPY Downside Hedges: Leveraged ETFs and Put Options
Summary
The document considers ways to hedge a long SPY position against a substantial decline: a volatility-linked ETF, an inverse leveraged ETF, and put options. It sketches possible gains and costs for each, but the proposed payoff estimates are uncertain and are not backed by a systematic backtest. The response highlights volatility decay in leveraged ETFs and the risk that inverse products can lose value when stocks rise.
For options, the discussion points to exposure to both price moves and volatility, balanced against premium decay and the need to choose strikes, expiries, and a rolling or monetization plan. It gives no tested comparison or allocation rule. The answer questions the expense of maintaining a hedge over time and suggests that lowering the equity allocation may be a simpler way to reduce drawdown risk. The suitability of any hedge depends on objectives, holding period, costs, and implementation details.
Key ideas
- Leveraged and inverse ETFs can suffer volatility drag and may lose value during rising markets.
- Long puts can respond to both underlying price declines and changes in implied volatility.
- Put hedging outcomes depend on strike, expiry, rolling, and how gains are monetized.
- The proposed hedge returns are rough estimates rather than backtested evidence.
- Reducing the underlying position is an alternative way to lower exposure to drawdowns.
Tags
Full text
# Pros and Cons of SPY hedging strategies # Pros and Cons of SPY hedging strategies Imagine someone bought 100K SPY as a long term investment. Now he wants to hedge against the downside risk of 10% or more. He is considering the following options: - Buy UVXY which is a 1.5X VIX ETF inversely correlated with SPY. If one buys 5K, in case of a 10% SPY crash, one would make ~50% or 2.5K (not sure how to calculate). Pros: No time decay. Cons: Price can drop very fast due to quick SPY upward movement. No exposure to change in volatility. Unpredictable upside. - Buy inverse 3x SPY ETF SPXL. If one buys 5K, in case of a 10% SPY crash, one would make ~30% or 1.5K. Pros: No time decay. Uniform 3x daily return compared to SPY Cons: Price can drop very fast due to quick SPY upward movement. No exposure to change in volatility. Limited upside. - Buy monthly or longer PUT options. If one invests 420 per month or ~5K/year, 10% drop would give 10X or more return Pros: One gets exposure to both change in price and volatility. Cons: OTM put options can lose value quickly due to time decay. ITM calls can be expensive depending on volatility. Now how can one find out which option is the best and what percentage of investment to put there? Is there any way to backtest different strategies? ## Answer by user42108 (score 2) https://quant.stackexchange.com/a/61657 re 1 and 2: You might want to Google something like 'volatility decay' or 'volatility drag' for leveraged ETFs. re 3: a quick look at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html suggests the long-term average return for US stocks is ~11.6% pa. You're proposing giving up ~5% pa to hedge. Not clear that's a good idea. also re 3: if you want to hedge, it's not obvious that simply buying and rolling puts is optimal. At the very least, you'd want to think carefully about expiry, strike, rolling strategy, monetisation and whether or not you delta hedge. My 2c: given that long-term realised vol in DM equities is ~20%, it seems odd to me that you'd want to hedge a 10% DD. I'd simply reduce the SPY position to a level where you can live with the vol/DD.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.