Managing Risk By Hedging

Anyone who’s ridden a mountain bike on a particularly difficult bike trail knows wearing a helmet may not keep you entirely free from harm.  If you fall on a steep descent, you’re likely going to get hurt whether you’re wearing a helmet or not.  However, falling while wearing a helmet may mean the difference between suffering a traumatic brain injury that permanently affects your function and living with a bad headache for just a day or two. 

Investing in the stock market can be as perilous to your financial health as riding a single-track mountain bike can be to your physical health.  Just like mountain bike trails, markets have significant ups and downs and investors can suffer irreparable harm if they’re not careful.  Thankfully, stock market investors have options to protect themselves through a risk management strategy known as hedging.

The following table presents several different ways to hedge an account that owns stocks or ETFs (exchange traded funds.)  Several of these strategies include buying or selling options, which have their own particular risks.  Please contact our office to obtain all the disclosures necessary to trade options on your account.

Let’s take a more detailed look at each of these strategies:

1. Cash: One of the simplest ways to hedge market risk is to have your money in cash.  Although we never recommend moving your entire portfolio into cash, an investor can have a higher allocation to cash during times of market volatility.  Cash typically has very low rates of return, but a significantly smaller risk of loss of principal than being invested in stocks.  The strategy works the best if an investor is perceptive enough to sell stocks during good times and allocate to cash as the economy slows.
2. Shorting Stock:  To short stock, an investor sells a stock that they don’t currently own.  The investors’ goal is to buy back the stock they are short at a lower price.  Profiting through shorting stock is the opposite of buying stock long.  Instead of seeking to buy low and sell high, here investors seek to sell high and buy low.  The risk to shorting a stock is that the loss can be unlimited as the stock rises infinitely.   Investors can minimize this risk by keeping the position to a smaller percentage of their portfolio.  Another way to effectively use a short is to pair it with a long stock position.  Known as a ‘pairs trade,’ the investor makes money even if both stocks go up together or down together as long as the long side of the trade outperforms the short side.  Pairs trading can also be accomplished with ETFs as there are many inverse ETFs that can be paired with long positions in a portfolio.
3. Buying or Selling Options: Options were created to allow one investor to pass off risk to another.  There are two types of options contracts: puts and calls.  We can use various combinations of these two option contracts to reduce volatility.

3.1.    Buy a Put:  One of the simplest ways to hedge with options is to buy a put against a position in the portfolio.  This trade would allow put buyers to sell their stock at a predetermined price.  This strategy can be expensive but effective if the market moves in a short amount of time after the option is purchased.

3.2.    Covered Call: A covered call is a call that is sold against a position in the portfolio.  By selling the call, investors receive cash, known as an option premium.  This premium can then be used to purchase a put.  While cheaper to own than buying a put outright, this strategy limits your upside because you have sold your right to the stock above a certain price. I like to use these where there is a downward market trend and I am less concerned about being “called out” of the stock.  Typically, these option strategies are structured for a period of 2 or 3 months.

3.3.    Put Spread: Another option trade is the put spread.  This trade involves buying a put against a stock in the portfolio and selling a put at a lower strike price.  Again, the sold put offsets the cost of the purchased put.  This trade is interesting because it would allow investors to sell their stock as the market falls, but then they are forced to buy it back at a lower price.

So why would investors want to hedge?  Investors typically hedge to eliminate or minimize the ups and downs in their portfolio.   Investors cannot hedge out all risk, and buying portfolio protection isn’t free.  Hedging a portfolio usually involves spending some money, which can be viewed as giving up some of the upside should the hedge not be necessary.  However, investors can use this to their advantage.  Imagine a scenario where the hedged stock or ETF drops 10% and the hedge is profitable by an equal amount.  Now the hedge can be sold and reinvested elsewhere.  If the belief is that the previously hedged security has good upside potential, the profits could then be reinvested back into that security. 

This article is to serve as a high level overview of a few different hedging strategies.  If you would like to learn more about options, the Option Industry Council has a great website set up to walk you through the many different option combinations here.   If you would like a closer look at how River Glen manages portfolios, please contact our office to schedule a meeting.

Paul Hassebroek

Director of Investment Strategy