Krishnan, The Second Leg Down

Investors, we know, are inclined to cut their profits short and hold on to their losers. In The Second Leg Down: Strategies for Profiting after a Market Sell-Off (Wiley, 2017) Hari P. Krishnan addresses investors who are seeing their portfolios shrink in value but are loath to sell. Anticipating further market declines, they want to hedge their portfolios. By then, however, traditional hedges such as index puts are expensive. Still, they need something to serve as a “hard backstop against portfolio disaster.”

Krishnan, who received a Ph.D. in applied math, was an options trading strategist at the Chicago Board of Trade and executive director and co-head of alternative asset allocation at Morgan Stanley. He is now a fund manager at Cross-Border Capital in London. Although he is writing primarily for institutional investors, many of his suggestions would work equally well for retail investors.

Options are the most affordable way to hedge a portfolio. When markets are going up, however, they are a waste of money. Month after month they expire worthless. So portfolio managers are disinclined to throw money away by hedging. When the flood waters are rising, however, they want to buy insurance—insurance that’s not prohibitively expensive. And they want to make money off that insurance.

Krishnan takes the reader through possible options hedging strategies, exposing the pitfalls of some of the more popular alternatives such as ratio and calendar spreads. Broken wing butterflies offer more advantages.

What about using VIX futures as a hedge? This doesn’t work; the hedge simply withers away over time. “Maintaining a long volatility position by mechanically rolling VIX futures is simply too expensive.” Simultaneously selling VIX futures and overbuying at-the-money VIX calls, however, is useful in risk-off regimes. “It benefits from large changes in volatility in either direction.”

Since options eventually expire, the question for a hedger is how far out in time to go. Let’s say you’re buying out-of-the-money puts. Short-dated options are cheap and insensitive to volatility. They are a gamma play, offering “tremendous potential when there are large realized moves.” They work well as an emergency hedge. Long-dated out-of-the-money options, those with more than a year to maturity, are best purchased when investors are overconfident. They occasionally offer exceptional value. It is wise to avoid those options that many institutions tend to favor—the 2% OTM 3 month to maturity puts. They are not a Goldilocks solution but rather “the worst of both worlds.”

Another portfolio protection strategy, an alternative to purchasing options, is to devote a portion of the portfolio to trend following. It is not capacity constrained (as weekly options in particular are) and, in a downtrending market, it will stay “piggishly” short.

I have outlined some of the main points of Krishnan’s book, but its real value comes from his sophisticated analysis of such critically important concepts as volatility and skew. This makes the book useful not only to hedgers but even to speculative options traders.