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How to Hedge Your Portfolio Against a Stock Market Plunge

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Record highs. Record angst.

Such is the predicament of many investors as the stock market keeps rising higher and higher. The historic advance has left many investment accounts plump with unrealized gains, and that is starting to make some investors fret about what comes next.

“Does a good thing go on forever? Human nature, and experience, suggest otherwise,” Michael Schwartz, Oppenheimer & Co.’s chief options strategist, told Barron’s.

Though it has been hard to be bearish about stocks for a long time, some investors are beginning to fixate on the unrealized gains in their portfolios. Rather than selling securities to lock in those gains—which is a profoundly difficult decision for all but the most disciplined—investors are looking at protecting them with options.

It’s impossible to quantify hedging activity, but defensive trading patterns are starting to emerge in the market. For the first time in ages, says Schwartz, the dean of the Street’s options strategists, clients have begun asking how to hedge stock portfolios in case something upsets the historic rally.

His clients aren’t citing any specific reason for a stock market decline. He says they just seem to have concerns that making money through investing won’t be as easy as it has been for so long.

The S&P 500 index is up about 80% since its March 2020 lows, and many stocks have surged even more.

To hedge, Schwartz has advised some clients to buy put options directly on the S&P 500. A $1 million portfolio can be partially hedged against a 10% stock market decline by buying three S&P 500 April $3,925 puts. Each contract costs about $6,530 when the benchmark index was at 3974. The total cost to hedge is about $19,590.

If the index declines by 10%, the portfolio will decline by about 0.8%, Schwartz says. If the index declines 10%, to 3553, the puts would be worth about $92,009. If the index is above the put strike price at expiration, the hedge fails, and the money spent on the puts is probably lost or seriously diminished. During the past 52 weeks, the S&P 500 has ranged from 2191.86 to 3981.04. The index is up about 6% so far this year.

Over the years, we have rarely discussed hedging strategies. Our preferred approach since the 2007-09 financial crisis has generally been to sell puts and buy call options. The existence of a massive “Fed put” minted by low interest rates has generally supported such a bullish posture. Ironically, this has helped to make hedging more reasonably priced for the first time in a long while.

In the past, the stock market needed to experience a massive correction for hedges even to be worth the expense. Now, hedging expenses have moderated for reasons that reflect deep changes in the options market.

Rather than just buying stocks, a new breed of investors is also buying loads of upside calls to further cash in on the rising stock market. This incredible bullishness among investors means that calls are often more expensive than puts. In other words, the market mob is arguably more greedy than fearful at this current moment.

Still, anyone who considers hedging must understand that hedges must be managed. They are not “set and forget” positions.

Many investors fail to realize profits on hedges because they get greedy, and hedges expire with little profit when the market rebounds. Determine in advance at what point you would monetize the hedge. Some investors will take profits at a 100% gain; others at 50%.

The key is just to take the profits, which can be as difficult to do on the downside as it is on the upside.

Originally Posted on March 18, 2021 – How to Hedge Your Portfolio Against a Stock Market Plunge

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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