- What you need to know about hedging with
- Inverse and leveraged ETFs
- Deciding which hedging instruments are appropriate for your portfolio
OK – hedging sounds prudent. But how do you do it?
Our focus here in Part 2 of this report is to cover the most common vehicles used in hedging strategies. Each one merits its own dedicated report (a series we’ll likely create in the future) to truly understand how and when to best deploy, so this report will focus on providing you with a good introduction to each, with guidance on how to further explore the ones that strike you as appropriate for your needs and personal risk tolerance.
Before continuing further though, let me make a few things absolutely clear. This is NOT personal financial advice. This material is for educational purposes only, and as an aid for you to discuss these options more intelligently with your professional financial adviser(s) before taking any action. (If you do not have a financial adviser or do not feel comfortable with your current adviser’s expertise with these hedging vehicles, we’ll be happy to refer you to our endorsed adviser)
Suffice it to say, everything discussed in this report (even the % cash component mentioned in Part 1) should be reviewed with your financial adviser before taking any action. Am I being excessively repetitive here in order to drive this point home? Good…
An easy way to limit your downside on large positions in your portfolio is to set stops.
(Stops can be used on positions of any size, but you’ll typically want to employ them on your largest ones first, where your exposure is greater.)
A stop order (also referred to as a “stop-loss” order) is used to trigger the sale or purchase of a stock once its price reaches a predetermined value, known as the stop price.
As an example, let’s say you bought a stock for $50. You may decide you want to sell your shares in the event the stock drops by 10%, so you enter a stop order for $45. Then, if the price of the stock subsequently drops below $45, your stop activates an order to sell the stock at market.
If instead of falling, the stock you buy climbs higher, your stop is not triggered and you continue owning the security.
As the name “stop-loss” implies, stops are intended to help you guard against experiencing uncomfortably large losses in your positions. You decide your maximum pain threshold, and the stop is designed to keep you from exceeding it. And your upside potential in the position remains unchanged.
You can also set a trailing stop order, which raises your exit price target as your position appreciates. Building on the above example, if your stock rises to $60, a 10% trailing stop order would then raise your stop price. A subsequent fall in the stock would trigger a market sale order in the event the stock retreats to $54 (90% of $60), rather than $45 if you hadn’t had the trailing feature in place.
Stops are one of the most useful, easiest to deploy and cheapest forms of portfolio insurance; but the majority of individual investors don’t use them. Why? Mostly out of unfamiliarity, which is a shame as they’re quite easily mastered.
There are a few risks with stops, though. The most important one to be aware of is that the more volatile a security is, the more likely it is your stop will be triggered. So even though a stock closes higher at the end of a trading day, it may have temporarily dipped down low enough to trigger your stop, causing you to sell at a loss. Moreover, in today’s HFT-manipulated markets, the dubious practice of “running the stops” has been known to happen. This is the nefarious act of a big player deliberately pushing the stock price temporarily to intentionally trigger the open stop orders. For example, it might start selling small amounts of a stock to push its price down in order to trigger the existing stops, then buy the stock back in larger volume at these lower prices before removing the selling pressure and allowing it to bounce back — making a quick profit at the expense of the stop holders it just fleeced. So give careful thought when you set your stop price, taking volatility into consideration.
Second, note that when a stop is triggered, it creates an order to buy/sell the security “at market” (i.e., the current market price). If the price is rapidly falling, it can fall further than your stop price before the market order is triggered. In extreme (and rare) cases, like a flash crash, your market order could potentially get filled at a fraction of your declared stop price.
Inverse & Leveraged ETFs
There are instruments that trade like stocks and allow you to bet against the direction of an index or an underlying benchmark asset. These are called inverse ETFs. They have a lot in common with the practice of shorting securities (which we’ll discuss in a moment), with the important distinction that they have limited downside.
Think the S&P 500 is overvalued and due for a correction? There’s an ETF you can buy (actually, many of them) designed to appreciate as the S&P loses value.
In this example, you could buy shares of the ProShares Short S&P500 ETF (ticker: SH) in the exact same way you buy shares of any other security. If your assumption is correct and the S&P declines in value during the trading day, the price of SH will rise on a (roughly) 1-to-1 basis. If you’re wrong, SH will decline on the same basis, but your worst-case scenario is losing no more than the money you put in (unlike shorting or certain options trades).
Now, let’s say you’re feeling really confident in your bet the S&P 500 is going to drop in value. Rather than SH, you could consider a leveraged inverse ETF like SDS, which inversely tracks the S&P 500 on a 2-to-1 basis throughout the day. Meaning you’ll make gains at twice the rate the S&P falls, and lose value twice as fast as it rises. But again, your downside is capped at the original principal amount you invested.
There are a plethora of inverse ETFs (leveraged and unleveraged) to choose among. A list of some of the most commonly traded ones can be found here.
Now for the caveats. Inverse ETFs have costs that erode performance over time. First, they require active management and therefore have fees. Second, they are designed to track their underlying benchmarks over the course of a single trading day. As time goes on, there are portfolio rebalancing costs that can eat into gains, and if enough time goes by, potential significant tracking error can cause the underlying performance of your holding to bear increasingly less relationship to the performance of the underlying benchmark asset. So, in general, when using inverse/leveraged ETFs, plan to hold them for shorter time frames. They are NOT “set it and forget it” holdings.
Shorting acts in much the same way as owning an inverse ETF, with some important differences.
Shorting a security essentially means selling it first (vs buying) because you expect it to go down in value. If it does, you then buy it back at the lower price, and pocket the difference between your initial sale price and ultimate purchase price.
Shorting generally works on a 1-to-1 basis; should the security you’re shorting drop by $1, you’ll make $1. Unlike inverse ETFs, this basis doesn’t decay over time or lose its connection to the underlying security. And there are no management fees to pay that may reduce performance. That’s why, in general, for longer-term bets, investors typically go short versus using ETFs.
But it’s critically important to be aware that the fixed 1-to-1 relationship works in reverse, too. If the security you’re short appreciates, your position will lose the equivalent amount. And since most securities have no theoretical limit on how high their price can go, your potential losses are theoretically unlimited, too. Should you be unfortunate to short the next Netflix right before its price takes a moonshot, you’d lose an awful lot of money — fast.
So, should you choose to short a security, consider using stop order similar to that discussed above (a buy stop order, in this case) to limit your exposure to losses.
One other thing to know about holding a short position: if the security you’re short issues a dividend, you will need to pay out that dividend. So be mindful of that risk when planning your shorts.
If you decide to employ shorting, you’ll be required to use a brokerage account with margin agreements. Margin refers to an amount you’re required to hold in reserve inside your account while your short trade is in play, as an indication that you can make good on the trade should it go against you. In the event that a security you have shorted moves sharply higher from the price at which you shorted it, you might be required to post additional margin (i.e., deposit additional cash) into the account in order to maintain your position. If you fail to post the required additional margin, your short position will be force liquidated by the brokerage. This provides another good argument for setting buy stop orders, which help prevent you from getting into this type of trouble.
Options are agreements to buy/sell a security (or other asset) at an agreed upon price at or before a specific future date.
They are more complex than the instruments mentioned so far, and because of this, they are deemed riskier. To trade options, you’ll need to apply for permission from your broker/brokerage, which will require signing your acknowledgement of the involved risk.
A call option affords the buyer the right to buy a security at a set price (called the exercise price) on or before a specified future date (the expiration date). The purchaser of a call option is hoping the underlying security rises in value before the end of the contract, so s/he can collect the difference between the market price and the (lower) exercise price.
To purchase a call option, the buyer pays an option price (commonly called the option premium) to purchase the contract. This is often expressed on a per share basis (e.g., $0.50), but typically represents 100 shares of the underlying security (making the total option price = $0.50 x 100 = $50). The value of the call option must rise above this option price paid for the investor to begin making a profit on the position.
If by the time the contract ends, the market price of the underlying security exceeds the exercise price, then the contract is exercised and the underlying security is “called away”. Essentially, the call option holder pockets the difference between the market price minus the exercise price, times 100.
However, if the exercise price is higher than the market price at the contract’s expiry, then the contract expires worthless. The investor loses the entire initial up front investment of the total option price s/he paid.
A put option afford the buyer the right to sell a security at a set price on or before a set date in the future. The purchaser of a put option is hoping the underlying security falls in value before the end of the contract, so s/he can collect the difference between the exercise price and the (lower) market price.
To purchase a put option, the buyer pays an option price to purchase the contract. Similar to call options, a put contracts is often expressed on a per share basis (e.g., $0.50), but typically represents 100 shares of the underlying security (making the total option price = $0.50 x 100 = $50). The value of the put option must rise above this option price paid for the investor to begin making a profit on the position.
If by the time the contract ends, if the exercise price is indeed higher than the value of the market price of the underlying security, then the contract is exercised and the underlying less-valuable shares are able to be “put” on the seller of the option by the buyer. Essentially, the put option holder pockets the difference between the exercise price minus the market price, times 100.
However, if the exercise price is lower than the market price at the contract’s expiry, then the contract expires worthless. The investor loses the entire initial up front investment of the total option price s/he paid.
Once purchased, the price of a call or put option will rise and fall based on several factors. The first is its intrinsic value, which is the difference between the market value of the underlying security and the exercise price specified by the option contract. The second is its time value, which is a multi-variate non-linear function based on several factors including how much time is left until the contract’s expiry, the implied volatility of the underlying security, and the “risk free” interest rate.
Due to the complexity of how option prices change and their great sensitivity to volatility in the securities underlying them, those who use them need to pay close attention to the price action. It’s not uncommon for an options contract to swing wildly from gain to loss throughout a single trading day.
It’s important to note that options contracts can be closed at any time prior to the expiration date (though if you wait until expiry, they will automatically be exercised if “in the money”). Your decision to cover (or “close out”) your options will be based on many factors, including (not not limited to) price, your future expectations for the price performance of the underlying security, remaining exposure to time decay, and others. The point is: you can exit your trade at any time you want prior to expiration (this differs from futures, which we’ll address shortly).
There are numerous strategies for trading options which would be folly to attempt to summarize in this high-level overview.
But for hedging, the most common use is as insurance against a drop in core portfolio holdings.
For example, if your portfolio is heavily long the general stock market, buying some “protective” put options against the S&P 500 would offer a measure of defense against a general market sell-off. Given the leverage involved with options (100 shares per contract), the magnitude of protection they offer when successfully exercised is outsized compared to their cost. Of course, if the S&P had risen by the contract’s expiry in this example, your contract would have expire worthless — but your loss on it was limited, and your larger position had appreciated in the interim.
Options are also frequently used for speculating, but for the purposes of this article, we’ll stick to hedging. The general strategy is to use them as you do car or fire insurance. Create a regular, affordable program where you pay for protection. If your contracts expire worthless, be happy about it — it means your core holdings are performing well. But if the market goes against your portfolio and your options get exercised, you’ll be grateful to have the proceeds to use in limiting your losses.
Suffice it to say, if you are not currently quite familiar with trading options, DO NOT start trading them until you have consulted a financial adviser experienced in their use. Yes, they can offer valuable insurance when intelligently used, but they are a fast way to lose money in the hands of the inexperienced.
Similar to options, a futures contract represents an agreed-upon transaction, based on an underlying asset or security, at a future date and price (called the spot price). Futures are frequently used for commodities, where producers hedge against volatility in the market prices of the goods they bring to market.
They differ from options in that futures require the transaction to take place at expiration. With options, the contract represents the right to transact, but does not obligate each party to go through with it. With futures, the transaction must occur. This can be done via physical delivery of the underlying asset (metal, corn, etc), but typically settlement is made in cash.
Purchasers of futures contracts are required to put down a margin payment of typically 5-15% of the contract’s value. This is done to promote confidence in the holder’s ability to afford the transaction at settlement date. If the market value of the underlying asset decreases, the holder will receive a margin call asking them to add in more capital in order to maintain the margin ratio required by the contract. Be warned: in the case of a price collapse in asset underlying the contract, losses from margin calls can be massive.
So, when would an individual investor prefer to use a futures contract over an option? It varies by investor preference, but a usual factors are transaction size (futures work well with large volumes), ease of trading (futures are a bit more straightforward — once your dedicated futures account is set up), and impact of time decay (futures have less than options). Bottom line: unless you’re an experienced futures trader, DON’T venture into the world of futures without the close guidance and counsel of a financial adviser well-seasoned in their use.
Deciding Which Hedging Strategies Are Appropriate For You
Here is where professional advice is well worth paying for if you are not already well-experienced with the hedging vehicles described above.
There are a mind-boggling number of combinations in which the above vehicles can be applied (writing a covered call on a leveraged inverse ETF, is just one example). As mentioned, a dedicated report on each is merited to get a real sense for their capabilities, nuances, and best practices.
And so we’ve intentionally just stuck to the plain vanilla options here. But even within this simpler sandbox, it takes a while to truly understand how these instruments work – particularly so with options and futures. Without experienced guidance, you’re practically assured to make costly mistakes that could have been avoided.
So, for the vast majority of you reading this: yes, you should serious consider hedging your current long positions given today’s market risk. That may be as simple as selling some securities to increase the cash percentage of your portfolio. But a range of the tactics discussed above may well be appropriate given your porfolio’s positioning, and your tolerances for both losses and risk. Discuss them with your financial adviser (or talk to our endorsed adviser if you don’t have one) and develop a plan. Even if you ultimately do nothing, at least make that a calculated decision. Don’t put yourself at risk of being one of the millions who will look at their statements after the next market correction and lament: Why didn’t I consider protecting what I had?