Hedging -- taking a position that offsets a primary holding -- is a method traders use to mitigate risk. If you own a portfolio of stocks and are expecting a crash, your initial impulse might be to simply sell your holdings, but there may be several reasons not to do this, including avoiding taxes on realized gains. By adopting a hedge strategy, you can insure your portfolio against catastrophic loss while leaving your gains unrealized and continuing to collect your stock dividends.
A put is the right to sell 100 shares of a stock or a stock index exchange-traded fund, or ETF, for a preset price on or before an expiration date. ETFs are baskets of stocks that match the composition of an index, such as the S&P 500. Puts gain value as the underlying assets decline in price. The most you can lose on a put is the purchase price, or premium. You can usually protect 100 shares of stock for three months for a few hundred dollars. You risk nothing more than the premium, even if stocks rise. You can buy puts on each stock you own, or instead on an index fund like the SPDR S&P 500 ETF, which might be much simpler to manage.
You can lock in the current value of your portfolio by opening matching short positions. Shorting a stock involves borrowing shares from your broker and selling them for cash. After the crash, you buy back the stocks at a fraction of their original prices, return the shares to your broker and pocket the difference. The money you make on shorting will exactly reimburse you for the losses in your stock portfolio, except for minor brokerage fees. However, as long as your long and short positions hedge each other, you won't profit if stocks rise.
You can sell stock index futures to hedge yourself against a crash. You need put up only the required margin in a futures brokerage account. Margin is collateral for your futures position and usually ranges from 2 to 10 percent of the futures contract value. When you sell an index future, you collect money if the index declines but must pay if it rises. Unlike puts, futures expose you to unlimited risk. However, should the stock index rise instead of fall, your primary stock portfolio will also appreciate, so the overall risk of a hedged futures position is usually small. Another alternative is to buy puts on the index futures contracts -- which, like all purchased puts, limits your exposure to the put premium.
Hedging Is Imperfect
Unless your portfolio of stocks happens to match an established stock index, hedging may not remove all downside risk. For instance, if you adopt a hedge that gains value as a major index -- for example, the S&P 500 -- loses value, you may find that certain of your stocks underperform the index. However, you can compensate for inexact hedging by buying extra put contracts. You risk only the additional premiums, but buy peace of mind should stocks crash as you predict.
- Hedging Market Exposures: Identifying and Managing Market Risks; Oleg V. Bychuk, Brian Haughey
- Equity Indexing: Hedging and Trading Stock Market Indices and Exchange Traded Funds; Andreza Barbosa
- Trading Futures For Dummies; Joe Duarte
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.