As a stocks near full-on bear market territory, long-only portfolio managers continue to get hammered on their portfolio hedging return.

Ilya Feygin, managing director at agency brokerage WallachBeth, believes that its time for traditional long-only money managers to throw their standard hedging strategies out of the window.

“Long-only investors typically buy 5%, three-month out of the money index puts and sell 10% three-month calls against their long positions,” Feygin said last week. “It seems logical to give yourself a little more room on the upside and a little more term on the downside hedge so there’s less time decay. However this strategy has been performing horribly.”

Feygin attributes this to the market receding, but not by enough to make the puts useful to their holders.

“If you look at the returns on the CBOE’s S&P 500 Collar Index, it has not added much value since the puts have had risk premia for volume, skew, and term structure priced in over the past five years, and there have not been busts of 15-20% down, which would make the puts useful,” he said. “Instead, there has been a series of corrections — down five, six, and eight percent.”

In that market environment, investors pay an excessive premium for their three-months out of the money puts since the size of recent corrections barely have put those puts in the money. Add in the loss taken by the underlying equity, and investors might begin to panic.

“When investors panic, they buy more protection when the market is down 5%,” according to Feygin “This is putting in more and more premium at a higher implied volatility just at the point when they should be monetizing. Hedging and taking money out has been a consistent theme, so they lose even more premium when the market bounces back.”

Instead, Feygin believes in such a situation, it would be better to sell the stock and the out-of-the-money puts and put spreads and tactically buy various upside payoffs. “This strategy tales a lot of the premium out, takes the stock that has 5% downside, and gets investors longer at a much more reasonable levels and provides some upside participation if there is a quick oversold bounce.”

Secondly, he suggested that investors use volatility-relate indices to hedge like the the VIX instead of relying solely on the S&P 500 because the volatility indices move up when there is a relatively small decline in the market.

As of early February the market correction was about 8% and the VIX jumped from 17 to 32 points, according Feygin. “It almost doubled on an 8% decline. That could prove to be an effective hedge if you lock it in, and each time there is the short-term recovering rally to a lower high, You will be able to buy the VIX at reasonable levels. Investors also could buy upside payoffs, of which they wouldn’t need that many because of their high beta.”

Featured image by James Thew/Dollar Photo Club