How To Hedge Your Portfolio

Chances are, you’re insured in numerous ways. If you have a car, you must legally have auto insurance. If you own a house, you almost certainly opt to insure it, lest a fire wreak havoc on your residence. And if you’re travelling to another country, odds are you buy insurance just in case you get seriously ill. In short, we purchase insurance to protect ourselves and our assets.

When it comes to your investment portfolio, an insurance company won’t be of much help. But that doesn’t mean there aren’t things you can do to protect yourself against the risk of a serious loss.

Generally speaking, these strategies fall into one of two categories: portfolio construction and hedging. By portfolio construction, I mean how you build your portfolio to withstand various potential shocks. Hedging, by contrast, is much more akin to traditional insurance. Indeed, according to the online dictionary Investopedia, the definition of hedging is, “Making an investment to reduce the risk of adverse price movements in an asset.”

Let’s first take a look at portfolio construction. It may sound cliché by this point, but it really does bear repeating: diversifying your investments will go a long way towards saving you from a permanent loss of capital. Meaningful diversification involves spreading your assets among different sectors, different regions of the world, and different asset classes.

When it comes to actual hedging strategies to guard against a bear market in stocks, investors are presented with a variety of possibilities. Unfortunately, many of them, while enticing on the surface, simply are not appropriate for most people.

Take so-called “leveraged Exchange Traded Funds (ETFs)”. These products have been widely advertised and are now quite popular. What they usually promise is to provide investors with two times the daily movement in a particular sector or market. A leveraged (bearish) ETF tied to the S&P 500, for instance, may go up 2% on a day when the underlying index declines by 1%. And on days when the market rises by 1%, the fund should decline by 2%.

This is music to the ears of investors who want to super-charge their returns. But the tune is misleading. Because of how these funds are constantly rebalanced, if you hold them for a week it is very possible that you will be disappointed by their returns. The market may in fact decline, as you foresaw, but the leveraged ETF that you bought to hedge the rest of your investments may also fall. These should only be used by the most nimble of traders.

Short-selling is another hedging technique that seems alluring but carries lots of risk. A short sale entails the borrowing and sale of a stock you don’t own in the hopes of buying it back later at a lower price. It turns traditional investing wisdom on its head: whereas the adage says “buy low and sell high”, short-selling aims to “sell high and buy low”. Why’s it risky? In theory, your risks are unlimited. If you short something and it soars, you will have a liability to buy back the stock you now “owe”. Again, best to leave this technique to professional traders.

If leveraged ETFs and short-selling are to be avoided, is there anything an investor can do if they’re worried about another serious market decline? There is, and it actually mirrors the sort of insurance we buy on our cars and our houses. The strategy involves buying what’s known as a put option on a stock market index fund (or a particular stock, if you happen to own a lot of one security). A put option gives you the right, but not the obligation, to sell a stock or index fund at a specified price on a particular date.

An example will be helpful. If you own Canadian mutual funds or ETFs, you might look at put options tied to the iShares TSX/S&P 60 index. This index fund comprises the largest 60 companies in the domestic market. At the time of writing, this fund trades at $22.08.

Say you are worried about the possibility that the TSX will take a nosedive sometime between now and March 2016. What you can do is buy a put option that gives you the right to sell the index fund at $22.00/share (basically the current price) in March of next year. Currently, that option will cost $1.38/share.

How many option contracts you would buy would depend upon the size of the investment you were hedging. For instance, if you had $200,000 of Canadian equity exposure, you would divide this by the current price of the ETF, $22.08. This gives you 9,058 shares that you’d want to hedge. Each option contract represents 100 shares, so 9,058 would then be divided by 100 to calculate how many put options you would need to buy (90 if you round down, 91 if you round up). How much would this cost? Multiplying 9,058 shares times the option price of $1.38 results in a total outlay of $12,500.04.

The $1.38 per share is known as the “premium”. It’s the amount you’re paying to someone who’s willing to agree to buy the index fund from you in March 2016 at approximately the current price. The risk the option seller is taking is that the market falls heavily (the very risk you’re hedging against).

A few things can happen if you buy this option. The market may go up, rendering the option worthless by the expiration date, but your investments tied to the TSX would rise. Another possibility is that the market falls by just a bit or stays flat. This is the worst outcome, because the option wouldn’t be worth much by expiry, and your underlying holdings wouldn’t go up to offset it.

Of course, your fears about a market decline could prove prescient. Let’s say the TSX falls by 25% before the option expires. This would translate to a price of $16.56 or so for the index fund. An option to sell the fund at $22 would then be worth roughly $5.44 by the time it expires ($22 minus $16.56). Having paid $12,500.04 to purchase the option, it would now be worth 9,058 times $5.44, for $49,275.52. Your net gain on the option would be $36,775.48. This would go a long way to offsetting the decline in your $200,000 in investments tied to the TSX (where a 25% fall would equate to $50,000).

Three words of warning on options: if you’re going to use them, stick to actually hedging your portfolio, as opposed to engaging in outright speculative trades. That’s best left, like the other techniques described above, to the pros. Second, you don’t always have to have your portfolio hedged. If you’re not concerned about the market falling considerably, buying insurance against the possibility of a decline may not make sense. Third, if you buy put options and the market does take a tumble, remember to sell the options before they expire. If the value of the index fund you’re hedging falls below the option price (i.e. the “strike” price) at the expiry date, your brokerage firm may convert the option into a short position. Going back to the risks of short selling we discussed above, that’s a scenario to be avoided.

Andrew Hepburn is a freelance writer based in Toronto specializing in economic and financial issues. From 2006 to 2009 he was a Research Associate with Sprott Asset Management focusing on commodity markets. ahepburn20@hotmail.com