How Hedging Strategies Enhance Diversified Portfolio

August 10, 2022

Since the beginning of 2022, a weaker macro-economic backdrop for both fixed-income and equity markets has resulted in relative poor performance of a traditional diversified portfolio of 60% U.S. equity and 40% U.S. bonds (60/40), with such a portfolio yielding -18.4% YTD (7/29/2022). Future economic events, such as interest rate volatility, quantitative tightening and slowing credit markets could spell more pain for debt and equity valuations.

Many investors follow the cornerstone of modern portfolio theory, diversifying a portfolio across multiple asset classes, as integral to managing portfolio risks and achieving enhanced risk adjusted returns. Alternatively, a portfolio’s risk can be managed using a hedging strategy with an allocation to an options-based strategy on the existing equity components.

Cboe’s S&P 500 Buffer Protect Index (SPRO)

To illustrate, let’s examine Cboe’s S&P 500 Buffer-Protect Index (ticker: SPRO), which measures the performance of a portfolio consisting of a monthly series of hypothetical exchange-traded Flexible Exchange® Options (FLEX® Options) based on the S&P 500 Index.

This strategy is designed to allow for upside participation of the underlying index to a capped level, which is determined on each annual roll date such that there is no premium or discount to enter into the hypothetical investment compared to an investment in the index. The downside buffer seeks to “buffer protect” against the first 10% of losses due to a decline in the S&P 500, while providing participation up to a capped level.

Source: Cboe Global Markets

The SPRO Index achieves this buffer of risk through a derivatives strategy on the underlying S&P 500 using six Cboe FLEX Option components whose strike price and expiration will be set on the roll date relative to the closing level of the S&P 500 Index on the roll date. These components are as follows:

  • Purchase 2 Call Options with strike = 50% of SPX closing price
  • Write 2 Type A Put Options with strike = 50% of SPX closing price
  • Write 1 Type B Put Option with strike = 90% of SPX closing price
  • Purchase 2 Put Options with strike = 100% of SPX closing price
  • Write 1 Type A Call Option with strike = 100% of SPX closing price
  • Write 1 Type B Call Option with strike = (𝑊𝑟𝑖𝑡𝑡𝑒𝑛𝑇𝑦𝑝𝑒𝐵𝐶𝑎𝑙𝑙𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) = 2 × 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑𝐶𝑎𝑙𝑙𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) − 2 × 𝑊𝑟𝑖𝑡𝑡𝑒𝑛𝑇𝑦𝑝𝑒𝐴𝑃𝑢𝑡𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) − 𝑊𝑟𝑖𝑡𝑡𝑒𝑛𝑇𝑦𝑝𝑒𝐵𝑃𝑢𝑡𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) + 2 × 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑑𝑃𝑢𝑡𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) − 𝑊𝑟𝑖𝑡𝑡𝑒𝑛𝑇𝑦𝑝𝑒𝐴𝐶𝑎𝑙𝑙𝑂𝑝𝑡𝑖𝑜𝑛𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖) − 𝑆𝑃𝑋𝑅𝑜𝑙𝑙𝐷𝑎𝑡𝑒(𝑖))

Managing Portfolio Risk: Diversification vs. Hedging

A portfolio comprised of 60% equities, 20% bonds and 20% to an equity derivatives hedging strategy known as “Buffer-Protect” (60/20/20) has only had a -14% drawdown YTD, which is roughly 4.4% less of a loss versus a traditional 60/40 portfolio. 

Source: Zephyr & Cboe Global Markets

Over an extended timeframe of 10 years, risk-adjusted return metrics of the hedged portfolio outperform those of a traditional diversified strategy. When a hedging component is added, the Sharpe ratio increases by 4 basis points to 0.90 versus the 0.86 of a 60/40 portfolio. Overall volatility measured by standard deviation also decreases significantly when a hedging strategy is incorporated into the portfolio, falling from 10.56% in 60/40 to only 8.35% in the 60/20/20 hedged strategy. This reduction in volatility is realized to the upside via a reduction in historic conditional value at risk, whereas the worst 5% of all monthly loss occurrences in a diversified portfolio are on average -5.43%. Compare this to the -4.26% average loss of a hedged portfolio.


Overall, we have seen how a portfolio allocation of 60% equity, 20% bonds, and 20% hedged equity strategy SPRO could offer investors seeking capital preservation and positive risk-adjusted returns a more attractive picture of risk/reward than a traditional 60% equity, 40% bond portfolio.

Learn more about the Cboe Buffer Protect Index, here.

Author: Spencer Simpson, Cboe Global Markets Derivatives Account Coverage Intern