An unconventional hedge has been creating 'turbo-charged' returns for worried stock traders
- Stock traders have been scurrying for downside protection amid heightened stock market volatility.
- There's one unconventional strategy that's been providing outsized hedging returns for investors in recent weeks.
Downside hedges have been a stock investor's best friend over the past couple weeks as major US indexes have slipped to multi-month lows.
While some traders might have guarded their positions using contracts on the Cboe Volatility Index (VIX), which trades inversely to the S&P 500 roughly 80% of the time, others have elected to short exchange-traded funds with broad market exposure.
After all, if those ETFs do their job and effectively track the underlying index, shorting them would seem to be the most effective - not to mention accurate - way to protect against losses.
But amid all of the recent hubbub, a different strategy has emerged as the most lucrative way to hedge, and it involves the shorting of single stocks.
From March 19 through March 31, shorting the so-called FAANG group - Facebook, Amazon, Apple, Netflix, and Google - has generated a 9.2% return, according to data compiled by financial analytics firm S3 Partners. That's more than double the 4.4% made shorting the ETFs designed to track the S&P 500, Russell 2000, and Nasdaq 100 indexes.
Further, while Tesla falls outside FAANG, it's still one of the most shorted stocks in the US market, and shorting it over the same period has yielded a whopping 16.7%, S3 data show.
"The thesis that shorting the FAANG stocks would act like a turbo-charged portfolio hedge because of their out-sized run-up in the bull market was a good call," Ihor Dusaniwsky, managing director of predictive analytics at S3, told Business Insider. "This does not mean that the ETFs did not perform as expected. It's just that the short FAANG stocks gave you better bang for your hedged buck."
While using single stocks as broader market hedges may seem like a novel concept to some, S3 Partners noticed it happening as far back as July 2017. And while the strategy was a money-losing proposition for much of 2017 as tech stocks led major indexes higher, it's paid off in spades for those willing to stay the course.
So what does the future hold? If recent dynamics are any indication, traders are staying cautious, which is probably the right move considering one eye-popping statistic suggests tech stock volatility is just getting started.
"Since we are not seeing significant stock covering to realize profits we can safely assume that a good portion of these shorts are being used as active hedges and will stay open to continue protecting the downside exposure of the long portfolio," said Dusaniwsky.
