By the time most people look to hedge their investment portfolios, the time to hedge has likely passed.
The most successful hedgers anticipate difficulties before others realize anything is amiss. They tend to be sophisticated practitioners betting on a stock market decline as much as they are trying to hedge.
When it seems as if nothing can go wrong, the market basically gives away inexpensive put options to anyone willing to buy them. But when stock prices fall—or when many investors are afraid of a decline—the opposite often happens. Hedging costs increase in response to demand. It’s like trying to buy insurance when your house is on fire.
Investors should consider this at a time when Wall Street is beginning to fret that this historic bull market may soon run out of steam. Strategists at major banks, including Bank of America , Deutsche Bank , and Morgan Stanley , have all recently warned that the stock market might finally correct.
The pullback concerns tend to cover the big headline woes, ranging from inflation, which may be more permanent than the Federal Reserve believes, to elevated valuation levels on the S&P 500 index and slowing economic growth caused by Covid-19.
Investors increasingly are eager to know what they should do to protect their stock gains. Guess what? The honest answer is probably nothing. By the time most people are asking about hedging, the best opportunities have likely passed.
Futures on the Cboe Volatility Index, or VIX, which offer a reasonable measure of how sophisticated investors view equity risk, are elevated. If the VIX futures curve could speak, it would say something like there’s no free lunch. This critical hedging indicator has already adjusted to the specter of a stock pullback.
Indeed, hedging activity in the S&P 500 has been active over the past month, with institutional investors buying hedges just in case stocks declined. Many of those hedges have been wasted because the market has kept climbing.
Still, the urge to hedge is growing—so here are eight pointers for small investors.
- The first 10% decline belongs to the market. If you cannot handle a 10% decline, you shouldn’t own your portfolio.
- If you must hedge, focus on puts that kick in at, say, a 11% drop or worse.
- Ideally, you will know if your portfolio follows a large-cap index like the S&P 500 or a small-cap one like the Russell 2000. Why is this important? If you have a large-cap portfolio, hedging it with a small-cap index fund is unlikely to provide protection.
- Understand the risks that are packed into the selected options expirations. If you were to construct a three-month hedge, for example, make sure you know what events, including earnings and economic reports, could trigger a decline or a rally. Time is expensive to hedge.
- Consider “put spreads”: Buy a put and sell another put with a lower strike price. The spread lowers expenses but limits profit because it creates trading ranges.
- If the market corrects, take profits. Don’t wait for a neutron bomb to explode. Use the hedge profits to buy another hedge if you are truly afraid.
- When you are so afraid of a market decline that you feel nauseated, every other smart trader likely feels the same. Extreme sentiment readings often precede rallies.
- If you want to get bullish during downturns, sell cash-secured puts that expire in a month or less, with strike prices that are just below the stock price. That enables you to buy quality stocks in moments of duress.
Byron wrote that we are the fools of time and terror. In the options market, the key is using those facts to your advantage.
Originally Posted on September 16, 2021 – Getting Nervous? 8 Rules for Hedging Your Portfolio.
Steven M. Sears is the president and chief operating officer of Options Solutions, a specialized asset-management firm. Neither he nor the firm has a position in the options or underlying securities mentioned in this column.
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