How to Hedge Against Falling Stock Prices

A hedging trade involves buying a security or derivative that will gain in value if the investment being hedged -- in this case stock prices -- decline in value. A hedge is not a trade for profit. It is a position taken to prevent losses. There will be a cost involved with any hedge strategy ranging from the cost of the hedge product to lost profits if your stocks go up in value, and the hedge produces offsetting losses. You can use a hedge to cover a portion of your portfolio value with the goal of having the hedge produce profits that offset some of the losses if the market declines.

Futures contracts trading against stock indexes may be one of the most efficient hedges against a declining stock market. Futures are standardized derivatives that allow buyers and sellers to contract for the future delivery of a specific commodity or financial instrument. Trading futures is more complicated than stocks, but if you are serious about hedging a large stock portfolio, learning about futures would add some useful tools to your portfolio management options. The trade-offs of using index futures as hedges are the requirement to have a separate futures trading account and the fact that a futures trade will fully offset stock value changes, eliminating any chance for a gain if the market goes up instead of down.

Put option contracts increase in value if the underlying stock or index declines below a pre-set level as defined by the specific put option parameters. Puts can be used to hedge the entire stock market through options on exchange traded funds -- ETFs -- or to hedge against declines in individual stocks. Only the money you pay for option contracts is at risk, so put options allow you to realize some profits if, instead of going down, your portfolio goes up by more than what you paid for the puts. Trade-offs include the relatively high cost of put options and the fact that options all have an expiration date. Not a good feeling if the market crashes the week after your protective puts expired.

Inverse exchange traded funds are designed to change value in the opposite direction of a specified index. Leveraged, inverse ETFs produce value changes of two or three times the index, again in the opposite direction. The purchase of a leveraged, inverse ETF in your stock portfolio would produce gains if the stock market declines, hedging the decline. These ETF products allow an easy to enter hedge to cover a small portion of your stock portfolio. The trade-off is an inverse ETF will drop like a rock in value if the market goes up.