As we mentioned in the post on portfolio risk, any investment portfolio is vulnerable to a range of different risks. No one knows for sure if, or when, there may be a market crash coming, but we can reduce risk with portfolio hedging and diversification.
Whether you are picking individual stocks or ETF investing, a variety of hedging strategies can be used to reduce downside risk, as well as other risks. In this post, we consider the different ways you can hedge a portfolio.
- What is portfolio hedging?
- How portfolio hedging works
- Ways of hedging a stock portfolio
- How to select a suitable hedge for your portfolio
- What does hedging a stock portfolio cost?
- Example of portfolio hedging
- Disadvantages of portfolio hedging
What is portfolio hedging?
A hedge is a strategy that mitigates against the risks to an investment. In many cases a hedge is an instrument or strategy that appreciates in value when your portfolio loses value. The profit on the hedge therefore offsets some or all of the losses to the portfolio.
There are several different risks that can be hedged. Moreover, there are numerous strategies to hedge these risks. Some portfolio hedging strategies offset specific risks, while others offset a range of risks. In this article we are focusing on hedging stock portfolios against volatility and loss of capital. However, portfolio hedging can also be used to hedge against other risks including inflation, currency risk, interest rate risk and duration risk.
How portfolio hedging works
You can implement a hedge to protect an individual security. However, if individual securities carry risk, it makes more sense to reduce or close the position. Investors typically want to protect their entire stock portfolio from market risk rather than specific risks. Therefore, you would hedge at the portfolio level, usually by using an instrument related to a market index.
You can implement a hedge by buying another asset, or by short selling an asset. Purchasing an asset like an option transfers the risk to another party. Short selling is a more direct form of executing a hedge. Hedges are very seldom perfect, and if they were, they would serve no real function as there would be no potential for upside or for downside. In many cases only part of the portfolio will be hedged. The goal is to reduce risk to an acceptable level, rather than removing it.
Ways of hedging a stock portfolio
As mentioned, there are many different ways of hedging stocks. We will start with five approaches using options, and then consider five other approaches to portfolio hedging. An option contract is an agreement that gives the buyer the right, but not the obligation to buy or sell an asset at a specific price. In some cases, an option can be executed anytime before the expiry date, and in others it can only be executed on the expiry date.
A call option gives the holder the right to buy the underlying instrument at the strike price. A put option gives the holder the right to sell the underlying asset at the strike price and is therefore most commonly used for hedging purposes. For put options, the option is said to be in the money if the current spot price is below the strike price. The option is out of the money if the strike price is below the spot price.
The price paid for an option is the premium. Deep in the money options are more expensive as they have intrinsic value. Options that are a long way out of the money have very little value, as there is little chance they will expire with any intrinsic value. The objective of an option hedge is to reduce the impact of a market decline on a portfolio. This can be achieved in a number of ways – using just one option, or a combination of two or three options. The following are five option hedging strategies commonly used by portfolio managers to reduce risk.
A long-put position is the simplest, but also the most expensive option hedge. Usually an option with a strike price 5 or 10% below the current market price will be used. These options will be cheaper but will not protect the portfolio against the first 5 or 10% that the index declines.
A collar entails buying a put option and selling a call option. By selling a call option, part of the cost of the put option is covered. The trade-off is that upside will be capped. If the index rises above the call option strike price, the call option will result in losses. These will be offset by gains in the portfolio.
A put spread consists of long and short put positions. For example, a portfolio manager can buy a put with a strike price at 95% of the spot price and sell a put with an 85% strike. Again, the sale of the put will offset part of the cost of the bought put. In this example, the portfolio would only be hedged while the market falls from 95% to 85% of the original strike. If the spot price falls below the lower strike, gains on the long put will be offset by losses on the short put.
A fence is a combination of a collar and a put spread. This entails buying a put with a strike price just below the current market level and selling both a put with a lower strike price and a call with a much higher strike price. The result is a low-cost structure that protects part of the downside while allowing for some upside.
A covered call strategy involves selling out of the money call options against a long equity position. This doesn’t actually reduce downside risk, but the premium earned does offset potential losses to an extent. This strategy is usually used on individual stocks. If the stock price rises above the strike price, losses on the option position offset gains on the equity position.
Now we come to some other approaches to hedging stocks, without using options:
Holding cash is one way to reduce volatility and downside risk. The less a portfolio has allocated to risky assets like equities, the less it can lose during a stock market crash. The trade-off is that cash earns little to no return and loses buying power due to inflation.
Diversification is one of the most effective ways to hedge a portfolio over the long term. By holding uncorrelated assets as well as stocks in a portfolio, overall volatility is reduced. Alternative assets typically lose less value during a bear market, so a diversified portfolio will suffer lower average losses.
Unlike cash, alternative assets generate positive returns over time, so they are less of a drag on performance. Hedge funds can also generate positive returns during a bear market because they hold long and short positions. Catana Capital’s Data Intelligence Fund uses real-time data to respond to changes in market sentiment. Because this fund responds to changing market conditions so quickly and holds long and short positions it acts as a hedge against volatility and downside risk.
Short selling stocks or futures
Short selling stocks or futures is a cost-effective way of hedging stocks against an expected short-term decline. Selling and then repurchasing stocks can have an impact on the stock price, while there is minimal market impact from trading futures. Selling a futures contract is a cheaper more efficient means of reducing equity exposure.
Buying products with inverse returns
Buying products with inverse returns is a relatively new method of hedging stocks. You can now buy ETFs and other securities that appreciate in price when the broad stock market loses money. Some of these instruments are leveraged, which requires less capital for a hedge to be implemented. The advantage of these securities is that they can be traded in an ordinary stock trading account, without the need for a futures or options account. However, before using them, they should be carefully vetted to ensure they inversely track the underlying security closely.
Buying volatility is another way to hedge equities that has become available recently. The VIX index is an index of implied volatility for a range of S&P options. There is an active market for futures based on the VIX index, and there are also ETFs and options based on these futures. Because volatility typically rises during market corrections, these instruments gain value when a long position in equities loses value. Buying volatility ETFs when the VIX is at historically low levels is an effective method of hedging. It should be noted that volatility products do typically lose value over time.
How to select a suitable hedge for your portfolio
There is no sure way to choose the best available options when hedging stocks. You can, however, consider the pros and cons of the available options and make an informed choice. You will need to consider several factors when considering your alternatives. The first decision will be to decide how much of the portfolio to hedge. If you are hedging an equity portfolio that forms part of a diversified portfolio, your entire portfolio is already hedged to an extent. In that case a smaller hedge would be required.
On the other hand, if all of your wealth is in equities, you would probably want to hedge at least 50% of it. You will also need to consider the portfolio and determine which market indices the portfolio most closely matches. Moreover, you should calculate the average beta of the stocks it holds. A higher beta will require a larger hedge. Also worth considering is how much upside you would be prepared to forfeit. Selling call options can reduce the cost of a hedge but will limit gains. Selling futures contracts will also limit your returns.
Once you have an idea of the type of hedge that would make sense, you should look at some indicative prices to work out how much appropriate strategies will cost. For S&P options, you can see a list of liquid option contracts here. For other indices, you can search for “X index option chain” to get an idea of prices. Once you have an idea of the costs you can weigh up the different strategies, how much each will cost and the level of protection they offer.
What does hedging a stock portfolio cost?
Hedging stocks with options requires the payment of premiums. The premium of an option depends on several variables including the current price of the underlying instrument, the strike price, the current interest rate, the time to expiry, expected dividends and expected volatility. While most of these inputs are fairly static, volatility is subject to supply and demand.
The following are approximate premiums an investor would pay for options on the S&P 500 index which is the most active option market in the world. In this case the average volatility level for the last 10 years of 17.8% is used. In these examples we assume the portfolio being hedged contains only S&P 500 ETFs.
Based on an index level of 2,950, a put option with a 2,950 strike and 180 days to expiry would cost 132 index points. This is equivalent to 4.4% of the index but protects 100% of the index value. The minimum and maximum loss for the next 100 days would be equal to the premium of 4.4%.
If the strike price was moved down to 90% of the index level at 2,655, the cost of the option would fall to 61 index points or 2% of the index. A long position would now have a minimum loss of 2% and a maximum loss of 12% for the next 100 days. A strike at 80% of the index value would cost just 0.8% of the index value but would still leave a portfolio exposed to the first 20% of downside.
If we extended the term of the option to 360 days, the at-the-money put option would increase to 6%, the 90% put would increase to 4%, and the 80% put would increase to 2% of the index values. For US markets you can view a hedge calculator on the CBOE website here. The examples listed above are just one aspect of the cost of portfolio hedging. Other costs include the transaction fees and commissions. Another cost is incurred when potential returns are forfeited by strategies that cap upside.
Example of portfolio hedging
As a hedging example, consider a portfolio worth $1 million. In this case the S&P 500 index has been chosen as the most appropriate index, but the average portfolio beta is calculated at 0.8. This means a full hedge would only need to have a nominal value of $800,000. The portfolio manager does not want the portfolio to lose more than 5% in the next year. The manager does not expect the index to rise more than 8% in that time.
With the index at 2950, a put option with a strike of 2,680 will limit losses to 4%. These options cost 116 index points. The manager can also sell call options with a 3200 strike for 91 points. These options will cap returns at 8.5% for the next year. The manager buys 3 puts and sells 3 calls, paying a net premium of 22 points. The 3 puts provide protection on $268,000 x 3, or $804,000 in total. The total premium paid is 22 x 3 x $100, or $6,600. This premium is 0.8% of the amount protected and is the minimum the strategy will cost.
The maximum loss for the portfolio over the following year will be 4.8% as the options cost 0.8% and protect the portfolio 4% below the current market level. The maximum gain will be 7.7%, with gains capped at 8.5% and being reduced by the 0.8% paid out.
Disadvantages of portfolio hedging
The process of portfolio hedging or hedging stocks is a trade-off. There is usually a cost, and there is no guarantee that a hedge will perform as planned. A significant hedging risk can come from a mismatch between the portfolio being hedged and the instrument being used to hedge. Constructing a hedge that accurately matches a portfolio is very costly, so the mismatch has to be accepted.
Hedging stocks can only be feasibly done once or twice a year. If the market rises after a hedge is implemented, the new gains won’t be protected. In addition, time decay devalues options rapidly as expiry approaches. The price at which options are valued in a portfolio is based on daily mark to market prices. These prices are subject to market forces and increase portfolio volatility even when they protect its ultimate value. Buying options requires margin to be paid out. To do this, cash has to be borrowed using the portfolio as collateral. This will usually come with a cost.
Conclusion: Hedge your stock portfolio to reduce market risk
Risk and uncertainty are a given when it comes to financial markets. While risks can seldom be avoided completely, portfolio hedging is one way to protect a portfolio against a potential loss. Hedging stocks does come at a cost but can give investors peace of mind. This can help investors take on enough risk to achieve long-term investment goals. Hedging can also prevent catastrophic losses if a black swan event occurs.