With the big run-up in stocks this year and many people expecting a pull-back or an outright bear market, perhaps you're getting nervous and looking for ways to protect the gains you've made. Hedging refers to taking positions that will reduce your loss should the market drop while still allowing for gains should the markets continue to perform well. Today I thought I'd discuss some hedging strategies for those who are looking for a little protection. Understand, however, that any hedging strategy you employ will reduce gains in the future.
In speaking about hedging we'll assume that the investor is primarily long to start with, meaning that the investor will make money if the stocks he/she owns go up in price. (When you buy a stock, bond, or mutual fund, you are "long." When you sell short or buy an option that goes up in price when a stock goes down, you're "short.") Most people are long most of the time and this makes sense because the market's long-term tendency is always up. Being short for a long period of time would be like entering a turbulent river and expecting to travel mostly upstream. Hedging a short position can also be done just by doing the compliment of the trades I describe. For example, buying a call option instead of a put option. (If you are not familiar with options, check out Options Trading: QuickStart Guide - The Simplified Beginner's Guide To Options Trading
One often associates hedging with risk, largely because of the term, "hedge fund" applied to the high risk/high return funds purchased by wealthy individuals. These funds get their names because they can take long or short positions, but often these funds are not hedging. Instead they are using large amounts of leverage to make large gains from relatively small movements in the markets. This causes a substantial risk of losing money. True hedging actually reduces risk.
To hedge is to take up positions that are designed to offset long positions, such that the investor will be less susceptible to losses due to falls in the market. For those who play roulette, you would be hedging a bet of $100 on red by putting $50 on black as well. You would be reducing the amount you would win if red were rolled since you would lose the bet on black, but you would also be reducing your loss should black be rolled since your small win on the black bet would reduce the loss on the red bet. If an investor is perfectly hedged, he/she will not lose money no matter what the market does. But by taking up these positions, one also limits or eliminates the possibility for making gains while the hedges are in effect. The following are ways to hedge a long position:
Selling shares of the same stock short- This is also called "selling short-against-the-box" and forms a perfect hedge provided that equal numbers of the shares are sold short as are held. No matter the movements in the stock, no money will be gained or lost. (Note that if the stock price goes up an investor would need to add cash to the account or pay margin fees, since this would result in negative cash balances in the account). Selling short-against-the-box has little purpose other than delaying gains from one year into the next for taxes.
Selling shares of other complimentary companies short- In this strategy, the investor sells short shares of a company that he/she expects to decline if shares of the company he/she owns fall in price. For example, if he owns McDonald's, he might sell shares of Wendy's short, figuring that is the market turns against fast food companies shares of both companies will fall.
Buying put options- A put option is a legal contract by which someone agrees to buy shares of a stock for a predefined price before a certain date. This can be though of as an insurance contract on the shares of the stock. In exchange for this agreement the owner of the shares gives the seller (called the writer) of the put a certain amount of money, called the "premium". For example, a put option for selling 100 shares of XYZ stock at 50, good for three months, might cost $300 when the price of XYZ was at $51 per share.
Writing covered calls on the stock - Here a contract is written that allows another individual to purchase your shares for a fixed price. This limits the amount the investor can make on the shares (since if they go up above the agreed to sales price they will be purchased for the sales price) but reduces losses somewhat if the shares decline in price due to the premium collected.
Buying short ETFs - This involves buying short exchange traded funds (ETF). These are financial instruments that are designed to go in the opposite direction of a particular market segment or index. For example, an owner of several mining companies might buy a short basic materials ETF as a hedge against a fall in commodities prices or a slowdown in goods production.
Selling a portion of the position The simplest way to guard against losses in a position is to simply sell some or all off the position, and is probably the best thing to do if you really need the money in the short-term since it is the most cost-effective way to be safe. This, of course, reduces the possibility of future gains, however.
If you're interested in individual stock buying and this strategy, I go into far more detail in my book, SmallIvy Book of Investing: Book1: Investing to Grow Wealthy
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.
