Hedge Tolerance and Position Tolerance

Marco,
I am looking for an explanation of what Hedge Tolerance and Position Tolerance means. Surely this must be documented somewhere.
Thanks

I find that varying “Hedge Tolerance” has no effect on whether the hedge gets increased or decreased. For example, with Hedge Tolerance set to 0% one of my sims increases the hedge by shortening 1 share of SPY for $193 with the hedge market value at $195,000.

When I set hedge tolerance to 5% I would expect no hedge increase or decrease to occur when the transaction would change the hedge market value by less than 5%, 5% of $195,000 = $9,750. However, this is not what happens. The model still increases the hedge by going short 1 share of SPY, no matter what setting I use.
So this setting does not work. I guess the idea was that small hedge transactions can be avoided by hedge tolerance setting. Can somebody check this please.

I could be wrong (often am) but this is what I think I know:

1)Hedge Tolerance is how far out of whack the hedge before rebalance. I think hedge tolerance of 5% means you can be 95% - 105% net long (assuming you have hedge set to 100% and tolerance of 5%)

2)Position tolerance. Assume you are market neutral. Your long side goes up 10% and your short side loses 10%. You didn’t make any money and your portfolio is flat. But your long side is up 10% - what do you do? You can’t increase your short side to match the long because you are increasing your leverage. Really, your long profit should be re-alloated to the short side and your portfolio equity is back to square one. But at what point do you do this? I believe this is position tolerance. It should calculate your net gain vs. your long portfolio capital and when the two are out by x% it sells off some positions to keep your leverage balanced.

This is what I think.

And sorry - I know you are asking for an answer from Marco. Just wanted to throw in my two-bits.

I think that P123 should explain what all this means. Here we have two users who don’t know what the settings mean.
In the meantime I found that hedge tolerance works only for long hedges, not for short hedges.

In long hedges it increases or decrease the hedge only if the percentage set times the hedge market value is exceeded, or so it would appear. For example, if I set hedge tolerance to 500%, the model enters the long hedge at inception and keeps the hedge constant at this level to the end. So this makes sense. But for a short hedge it does not do that, it varies the hedge over time even with a high setting of 500%.

Kurtis, you have a market neutral R2G model that is 100% hedged by shortening SPY. You can vary the hedge tolerance setting and you should find absolutely no change of the model. Let us know whether this is correct.

Hoo boy, I hope that I get this right:

  1. Hedge tolerance is how large a trade has to be as a percentage of the hedge position before a trade is generated simply to adjust the hedge back to the target percentage.

If you have $10,000 in a hedge and the tolerance is 5%, the individual trade needs to be $500 before the portfolio will act upon it.

  1. Position tolerance is the same thing, just with the total value of the “regular” positions. The thought is that the hedge is generally going to be a much larger position than the other positions of a hedged portfolio, and you’d want to adjust the tolerance of hedge v. regular portfolio holdings differently.

So if the positions were also $10,000, but were comprised of 10 holdings, and you also had 5% as your position tolerance, you would need trades averaging $50 each for the trades to be posted. That’s pretty low, so you might want to raise it to 10%, in which case the average would be $100 each.

As you can see I understood 1) to be exactly as you explained. Problem is that 1) does not work for a short hedge, works fine for long hedge.

Why has “Hedge Tolerance” setting no effect on short hedges, but does work for long hedges?

There was a problem with hedge tolerance with short hedge. I think it was adjusting it all the time. It’s fixed now, should not be a big effect overall.

Thanks for reporting it.

PS. having only weekly adjustments the hedge tolerance is not that significant . When we have daily rebalancing , that’s when the tolerance should be important

pdemartino wrote:
"2) Position tolerance is the same thing, just with the total value of the “regular” positions. The thought is that the hedge is generally going to be a much larger position than the other positions of a hedged portfolio, and you’d want to adjust the tolerance of hedge v. regular portfolio holdings differently.

So if the positions were also $10,000, but were comprised of 10 holdings, and you also had 5% as your position tolerance, you would need trades averaging $50 each for the trades to be posted. That’s pretty low, so you might want to raise it to 10%, in which case the average would be $100 each."

A little confused as to this explanation. So at $10,000 and position tolerance of 5% (or $500) - what do you mean about this being the threshold for trades to be posted? I don’t get this.

What I thought is that your actual net portfolio value (long and short combined) must be within 5% of the long side of the portfolio. If your net value is $100K - your long side better not show $110K or else your margin is sneaking up there. You need to sell off some of your long side and get the long portfolio to be within 5% of the actual equity. But maybe I am wrong. This prevents someone from leaving their long side and increasing the short side during the bull market.

As an example - you have $100K long and 100K of short value on margin. Long side goes up to $200K and short side goes to 0. So you add another $200K on the short side? Your net value is still only $100K but you now have $200K on the long side and $200K on the short. Your margin is all out to lunch. So I thought (the word here is thought) that if in this example the net value never goes above $100K - the portfolio will keep resetting and keeping the balances in check when the long side of this portfolio goes above $105K because it has deviated more than 5% from true equity.

Is this understanding correct?

Thanks Marco, it was previously indeed adjusting all the time with minute transactions. Now this has been fixed and it works great.

Of course, all the R2G models with short hedges have to be recalculated now, because they were all affected by this error. Especially those with market neutral strategy with permanent short hedges will be most affected by this. Since historic data for ports and R2G models is frozen, all those models will show incorrect results now. Only sims will be accurate when recalculated.

I just ran it. Here is the old versus the new.

Hemmerling S&P 500 Market Neutral Strategy
Old Stats:
Annualized Return 20.85%
Annual Turnover 516.73%
Max Drawdown -13.03%
Overall Winners (967/1723) 56.12%
Sharpe Ratio 1.43
Correlation with S&P 500 0.14

New Stats:
Annualized Return 22.07%
Annual Turnover 529.69%
Max Drawdown -14.65%
Overall Winners (967/1609) 60.10%
Sharpe Ratio 1.51
Correlation with S&P 500 0.15

Great, better returns now. What hedge and position tolerances do you use?

2% hedge and 5% position