What Goes Up Must Come Down

By: Robert Hahn, CFA and Robert Cagliola, CFA

Introduction

“What goes up, must come down” was first stated by Sir Isaac Newton to describe his Law of Universal Gravitation. The statement applies equally well to both falling fruit and stock market fluctuations. In this article we will focus on the most important attribute of option-based strategies which is the ability to reduce volatility while remaining invested in the stock market. In particular, we will discuss our hedged equity strategy and how a hedged equity allocation can potentially improve the risk or reward profile of a portfolio.

Why Would an Investor Want a Hedged Equity Allocation in Their Portfolio?

A former colleague often said, “Trees don’t grow to the sky,” meaning that stocks cannot go up forever. While the market, as represented by the S&P 500® Index, has returned on average about 10% per year since 1928, the path can be bumpy. The market typically experiences several pullbacks greater than 5% each year. As a result, many investors have historically allocated less of their portfolios in equities despite the market's attractive long-term return. We believe that a hedged equity investment can be the answer for investors who are looking for an investment that can reduce downside participation during pullbacks. The chart below illustrates the potential benefits of using an option-based strategy to reduce volatility. There have been eight pullbacks of 5% or greater since inception through December 2024. Figure 1 compares the performance of our hedged equity strategy versus the S&P 500® since inception on January 19, 2022. As shown in Table 1, the hedged equity strategy experienced significantly less downside than the market during each of the 5%+ pullbacks, averaging less than 62% of the market downside over the eight pullbacks.

Figure 1. Performance During Market Pullbacks of 5% or More

Table 1. Downside Participation During Market Pullbacks

Can I Have My Cake and Eat it Too?

While the potential lower volatility associated with hedged equity strategies is attractive to many investors, it begs the question whether hedged equity investments can still participate in a significant portion of potential market upside, also known as having your cake and eating it too. Figure 2 shows the growth of a $10,000 investment in our hedged equity strategy. The value of a $10,000 investment on January 19, 2022 resulted in an investment value of $13,384 on January 31, 2025, or nearly 96% of the return of the S&P 500 but with approximately 2/3 the volatility of the market as measured by standard deviation.

Figure 2. Growth of $10,000

How is the Portfolio Constructed?

Our hedged equity strategy utilizes a total return strategy that attempts to participate in a significant amount of potential market upside while utilizing call writing and puts and put spreads in an attempt to reduce volatility. As shown in Figure 3, the portfolio consists of three segments: 1) an actively managed and diversified stock portfolio of 40-50 names, 2) call writing on the individual positions to reduce volatility and increase income and 3) use of puts and put spreads to further dampen volatility and to attempt to lessen downside participation in the event of larger sell-offs. The foundation of our approach is a core portfolio of carefully selected large cap equities. Our emphasis is on fundamental quality, strong profitability, low debt and proven management. We target an above market dividend yield which is supplemented through call writing resulting in a targeted gross cash flow of 4-7% per year. We note that given our total return focus, net cash flow can vary as the portfolio managers may choose to roll an in the money option where it makes sense to participate in additional potential upside in the underlying stock while maintaining the cost basis of the stock. This allows us to potentially participate more in up markets, while generating more income during downturns given higher volatility and fewer in-the-money rolls.

Figure 3. Investment Process

Premium Generation

As mentioned previously, call writing and premium generation is an essential element to the reduced volatility experienced by our hedged equity strategy since its inception. Many factors drive levels of capture including market expectation of macro volatility as measured by the VIX® Index, idiosyncratic issues related to the individual underlying stock position and) duration and strike price versus the current price of the stock. Figure 4 shows the average premium collection in various volatility environments since the strategy’s inception. Generally, the higher the market volatility, the increased ability for premium generation that potentially dampens overall portfolio volatility.

Figure 4. Premium Generation vs. VIX Index

How Has Hedged Equity Strategy Performed?

As shown in the tables below, our hedged equity strategy captured a significant portion of the market’s appreciation since inception through January 31, 2025, with approximately 2/3 the volatility of the market as measured by standard deviation. We believe that the addition of a hedged equity allocation to a portfolio could enable investors who are sensitive to market volatility to remain invested in the stock market with lower volatility or enable them to increase the equity allocation in their portfolios.

Table 2. Hedged Equity Strategy vs. BXM & S&P 500

Table 3. Portfolio Risk Metrics

Summary

While Newton’s law stating that what goes up must come down is indeed true, with regard to investments, the addition of a hedged equity strategy may help cushion the fall by reducing the downside participation while potentially participating in a substantial portion of potential market upside. To investors who are more sensitive to volatility, including a hedged equity strategy may enable them to increase their equity allocation while keeping volatility at a more acceptable level.

Connors Investor Services has been helping clients with option-based solutions for over 50 years. Our hedged equity strategy is available in a mutual fund.

About the Authors

Robert J. Cagliola, CFA, Vice President

Robert Cagliola joined the firm in 1999. Previously, he was employed by Miller Anderson & Sherrerd, an asset management firm in West Conshohocken, PA, and as a Portfolio Analyst with SEI Investment Co. in Wayne, PA. Rob received a BS/BA degree in Finance and Economics from Shippensburg University in 1989, an MBA from Temple University in 1995, and the Chartered Financial Analyst® charter holder designation in 2000. His responsibilities include co-portfolio management and equity research on the Connors Income and Growth, Connors Covered Call strategy and a variety of option related strategies.

Robert W. Hahn, CFA, Vice President

Robert Hahn joined the firm in 2017. Previously, he worked in equity research at Raymond James, a brokerage firm in St. Petersburg, FL. He was also employed as a Senior Equity Analyst with Eagle Asset Management in St. Petersburg, FL. Bob received undergraduate and graduate degrees in Electrical Engineering from Villanova University, an MBA from Indiana University, and the Chartered Financial Analyst® charterholder designation in 2002. His responsibilities include co-portfolio management and equity research on the Connors Income and Growth, Connors Covered Call strategy and a variety of option related strategies.

Disclaimers

^{All table and chart data is from FactSet.}

^{This article is part of Cboe’s Guest Author Series, where firms and individuals share their insights, strategies and ideas with the broader Cboe community. Interested in contributing? Email social@cboe.com or contact your Cboe representative to learn more. Neither Connors’ investment advisor registration status, nor any amount of prior experience or success, should be construed that a certain level of results or satisfaction will be achieved A copy of Connors current written disclosure and Form CRS continues to remain available upon request at www.connorsinvestor.com.}

^{The comments, opinions, data, and analyses expressed herein are for informational purposes only and should not be considered individual advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions, data, and analyses are rendered as of the date of this report and may change without notice. The information contained herein is not guaranteed as to accuracy or completeness. All performance data are historical and do not guarantee future results.}

^{This commentary is not intended for the giving of investment recommendations to any single investor or group of investors, and no investor should rely upon or make any investment decisions based solely on its contents. All returns are shown net of fees. The indices shown are for informational purposes only and are not reflective of any investment. As it is not possible to invest in the indices, the data shown does not reflect or compare features of an actual investment, such as its objectives, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, or tax features. As it is not possible to invest in an index, the information shown does not reflect the features of an actual investment, such as objective, cost and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, or tax features. The Strategy involves risk, including the possible loss of principal. There is no assurance that the Strategy will achieve its investment objectives. The use of leverage embedded in written options will limit the Strategy's gains because the Strategy may lose more than the option premium received. Selling covered call options will limit the Strategy's gain, if any, on its underlying securities, and the Strategy continues to bear the risk of a decline in the value of its underlying stocks. The S&P 500® Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value-weighted index (stock price times the number of shares outstanding), with each stock's weight in the Index proportionate to its market value. It is widely used as a benchmark of U.S. equity performance. Standard deviation is a statistical measurement of volatility risk based on historical returns.}

^{Investments in options involve risks different from, or possibly greater than, the risks associated with investing directly in the underlying securities. The S&P 500® Index is a capitalization-weighted unmanaged index of 500 widely traded stocks created by Standard & Poor’s. The index is considered to represent the stock market's performance in general. Indexes do not incur fees, and it is not possible to invest directly in an index.}