Here’s The Truth About Portfolio Hedging

| December 16, 2011 | 0 Comments

Confused about how to hedge your stock and ETF portfolio?

If so, you’re in luck.

In a moment, I’m going to show you the simplest way to hedge your stocks and stock-based ETFs.

But before I say any more… I first need to expose a few dangerous hedging techniques you should ignore like the plague.

Diversification has long been touted as the best tool to manage risk.  And it still can be in some respects.  But there’s nothing more disappointing then watching your diversified assets all going down together.

You see… there’s usually a high correlation between stocks and indexes. Simply put, in a stock market free-fall, everything suffers in some way or another.

Another popular way to hedge is through precious metals.

History has shown gold and silver usually move inversely with stocks.  But I would be careful about plunging into metals like gold or silver to hedge.

Precious metals are more and more frequently moving in lock step with stocks.  To be effective, your hedge most move opposite of the asset you’re trying to hedge.  So, precious metals aren’t an effective way to hedge stocks right now.

Lastly… unless you’re a professional trader, do not use this hedging technique…

I’m talking about using the CBOE Volatility Index (VIX).

The media has done a great job of convincing everyone the VIX is the best hedge for stocks.  But, like I constantly tell my kids, “Don’t believe everything you see or hear on TV.”

Here’s the problem… using the VIX as a hedge isn’t as easy as it sounds.

You see, most investors can’t buy the VIX itself.  If you could, it would certainly make hedging much easier.  But the VIX is an index, and it can only be bought through futures contracts.

Futures contracts!?!  Need I say more?

What’s worse, the other tradable VIX related products like futures options and ETFs aren’t ideal either.  These products are highly complex and carry various costs which make execution and selection near impossible.

The point is, Wall Street has come out with a number of products that make hedging stocks look easy.  But, as you know… there’s no such thing as a free lunch.

So… what’s the best way to hedge your stocks and ETFs?

Drum roll please… the simplest and most effective way to hedge is to buy put options on your positions.

If you own a concentrated position in one stock, a basket of stocks, or an ETF, buying put options is the most direct hedge.

It’s like buying an insurance policy on the exact asset you need to protect.

We do this all time!  Need to protect your car?  You buy car insurance. Need to protect your home?  You buy home insurance.  It’s no different with stocks and ETFs.

And there’s more…

Like any insurance policy, you get to set the terms of your coverage.  You decide the premium, deductible, and the duration of your policy.

Here’s what I mean…

Let’s say you purchased 100 shares of Microsoft (MSFT) a few months ago at a price of $20 per share.  But today you’re worried the European debt crisis will bring about another market downturn.  However, at the same time, you see a potential Santa Claus rally sending MSFT higher.

So, how do you protect your downside without giving up an opportunity for profits?  Simple, buy a put option “insurance policy”.

All you’ll need to do is pick your premium (the price of the option) and the term of your policy (expiration month).

For instance, you can buy a February $25 put option for $0.85.  Meaning, the term of your insurance is from today through the third Friday in February (expiration) for a price (premium) of $0.85.  Since each put option covers 100 shares of stock, your total cost is $85 ($0.85 x 100 shares).

How do your puts protect your shares?

Your put option “policy” says you can call your broker anytime between now and the third Friday in February (expiration) and tell him you’d like to exercise your put option.  At this point, the broker must take your 100 shares of Microsoft and sell them at the strike price of $25 per share.

Now, let me do some quick math.  Your initial purchase of Microsoft was $20 a share ($2,000).  You paid $0.85 a share ($85) for the $25 put option.  The result… an ongoing sell stop at $24.15 ($25-$0.85).

Now you have guaranteed protection for your Microsoft shares.  Even if a catastrophe drives Microsoft down to zero, you’ll still net $24.15 for every MSFT share you own.  It’s just like filing a claim with your insurance agent.

In this crazy market, you need to insure your investments.  You need to be able to sit down and relax for the holidays.  You don’t want to spend your days worrying about losing your shirt in the market.

And you certainly don’t want to get into some crazy complex hedging strategy that uses multiple options and mathematical methods.

The best advice is to keep your hedging strategy as simple as possible. And the simplest, most effective hedge is using put options to protect your stocks and ETFs.

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Category: Options Trading

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