The idea of hedging a portfolio is incredibly seductive: Get exposure to the market’s upside, but limit your downside. Who wouldn’t want that? Unfortunately, there are hidden tradeoffs that you don’t see until you try to offset risk in the real world. Today, I’ll explore the various approaches for portfolio hedging. As with all things in trading, there isn’t a single best approach. Instead, each path offers its unique tradeoffs.
My job is to help you make a more informed decision.
Your job is to make the choice that best helps you reach your goals.
What is Portfolio Hedging?
Hedging a portfolio is all about reducing your risk. What you’ll quickly discover, however, is that you’re not getting something for nothing. When you lower your exposure to downside risks, you inevitably shrink your exposure to upside reward. Three examples will illustrate: selling covered calls, buying protective puts, adding other bearish trades to your account.
One common way to offset risk is to sell calls against your stock holdings. The premium you receive offsets small losses in the stock. But it also obligates you to sell your shares if the stock rises too far.
Another route involves buying a put option. Suppose you own 100 shares of a $100 stock and purchase a 90 strike put for $5. Though you’ve limited your downside to $15, you also now have to make $5 on the shares just to break even. In other words, the first $5 of gain in the stock will go to paying for the insurance.
Suppose you have ten bullish positions and are uncomfortable with the amount of exposure you have. As established, you could sell covered calls or buy protective puts. But you could also deploy other bearish-leaning trades. A portfolio with ten bullish positions and four bearish positions will have less overall risk.
My Preferred Hedging Path
I have a preferred order for which actions I take to reduce risk. They are listed in order of most to least desired.
First: Close bullish positions. Subtraction is far easier than addition. If you’re nervous about market conditions or feel that you have too much exposure and aren’t comfortable with what your drawdown will be if we experience a garden-variety correction or bear market, then by all means, reduce exposure. But don’t jump straight to buying expensive insurance. Just close out some of your trades.
For me, this is the easiest and most common path I take. Readers who are in the Team Phoenix Trading Lab will recall we’re tracking something like 17 positions. Sixteen of which are bullish. Let’s pretend this represents your total portfolio. The reason why we are following so many trades is that the market is healthy. Suppose bears come to town next week and spoil the fun. The first thing I’ll do is rapidly pare down positions. While I may not go from 16 to zero, I will at least lower it to ratchet down exposure
Admittedly, these are all shorter-term spread trades. Were I to close them all, it would eliminate my risk of further loss to zero. However, sometimes this isn’t feasible for those with longer-term stock positions. So what’s option number two?
Second: Sell Covered Calls. I don’t always sell calls against stock positions. Sometimes the stock is too bullish. Other times, there simply isn’t any premium available in the calls to make it worth it. Still, other times I don’t have enough shares. But rest assured, if I own 100 shares of a stock with liquid options and good premium, I will sell calls against it when prices break support.
Three: Add Bearish Trades. I don’t like to force this one. Lately, the market has been extremely bullish, and I’ve found it challenging to make money with bearish trades. And, honestly, this is usually the case. Nonetheless, it does reduce risk. So, if I don’t want to close bullish trades, and I’ve already sold what calls I’m going to sell, and I still want to pare down exposure – I’ll tack on some bear trades. Which ones I use depends on what kinds of setups I find. If the market is overbought and IV is low, I’ll use scaling to put calendars on something like SPY, QQQ, or IWM.
Fourth: Buy Portfolio Insurance. The most effective way to limit your risk is to buy put options on your stock positions. You can do this on each one individually or beta weight your portfolio to buy puts on a single index. I teach all about how to do this in the Bear Market Survival Guide. While it’s the most effective way of limiting risk, it’s also one of the most expensive. Of course, you could try buying put spreads to cheapen the cost somewhat, but it’s still my least preferred choice.
Do All-Time Highs Make Me Nervous?
Sometimes the cry for insurance comes because of comments that the market is too high or at a record. The phrase, “what goes up must come down,” enters traders’ minds, and they decide they should buy insurance. While I can appreciate the sentiment, the truth is record highs are bullish, not bearish. The S&P 500 has made over 50 record highs this year. And not a single one of those preceded an epic crash. If you want to know how often the market makes a new record high, read this article I penned back in 2015.
If carrying insurance on your portfolio is what you need to allow you to participate – then fine. Do it. Being in the market and having some exposure is better than sitting in cash and getting fleeced by inflation. For myself, I’ve discovered that ratcheting down exposure by closing short-term trades and selling covered calls is a potent enough combo to deal with downturns. What’s more, the money I’m investing won’t be used for decades. As such, I view whatever bear market comes my way as temporary.
Why twist myself into knots trying to hedge away downturns that will eventually heal themselves anyway?
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