These markets are some of the most vicious in history with the Dow plunging over 38% (more than 11,000 points) from its high in a month & a half, then bouncing over 20% in only 3 days. These are historically volatile times.
Many people are worried about their equity exposure, and after the massive rally that we saw the past few days, it would make sense to start hedging against further losses. History has shown us that we are likely to retest our lows, which we hit on Monday. When the Dot-com bubble burst in the early 2000s, the market had three 20%+ rallies before finally hitting its lows in 2002.
I want you and your portfolio to be protected. In this piece, I will discuss a few hedging options to reduce your downside risk.
There are multiple effective ways in which you can hedge yourself against downside market risk. You could buy a put option, you could sell a call, or you could purchase an inverse ETF. All these hedging strategies have risk/reward trade-offs, and I will go through each of the possible hedges.
Buying Put Options
Buying a put gives you a direct hedge at the strike price in which you purchase the option. This would typically be my preferred hedging method, but recent volatility has made this method quite expensive.
A put is a contract that gives you the option to sell stock (100 shares per contract) at a predetermined price, the strike price. In order to purchase a put contract, you must pay a premium for the option which is determined by the following equation:
(strike price – current stock price) + maturity risk (the longer the expiration, the larger the risk premium) + implied volatility (how fast the stock price moves)
Right now, implied volatility (IV) is excessively high for almost every stock on the market, which is making option premiums costly. The VIX (volatility index) determines the IV of the broader market, and this index is trading at its highest levels since the heart of the 2008 financial crisis.
These option premiums are quite rich, and this means that you are risking a lot more than you would in normal market conditions. The volatility premium may be warranted, but it is adding risk, especially if you believe volatility has hit its peak.
My recommendation, if you were to choose this hedging avenue, would be to buy an index-tracking ETF put such as S&P 500 tracking SPY (SPY - Free Report) or Nasdaq 100 tracking QQQ (QQQ - Free Report) . This will allow you to hedge your entire portfolio with one manageable set of contracts. Make sure that your strike price, contract expiry, and volume is in line with your portfolio exposure and what you are comfortable with.
Sell Call Options
This is my recommended hedge if you own the shares to cover (which I will explain later). Writing a call will allow you to cash in on the massive premiums that these options are trading at due to the implied volatility I discussed above. The equation for a call option premium:
(current stock price – strike price) + maturity risk (the longer the expiration, the larger the risk) + implied volatility (how fast the stock price moves)
Selling (or writing) a call may sound abstract because you don’t have anything physically to sell, but the contract obligations are relatively straight forward. When you sell a call, you’re immediately credited with the premium from the purchaser. The contract you sold gives the buyer the right to buy the specified shares from you at or above the strike price, between now and when the contract expires.
For me to be comfortable with selling a call I would want to be covered, meaning that I own the underlying shares specified in the contract (remember that each contract corresponds to 100 shares).
If your call is uncovered and the stock or ETF suddenly surges to no end, you are exposed to an unlimited downside. You would be required to buy the underlying stock at expiration (or whenever they decide to execute the option) and sell it at the strike price to the corresponding party, taking a loss of whatever the difference between the two is.
If you choose this method, I recommend writing calls that are somewhat out of the money so that you can still enjoy some of the stock price upside potential, but not too far out that you don’t receive a sufficient premium. Shorter expiration is less risk (lower risk premium), but you can rollover to another contract when the current one expires (if your view remains bearish).
This hedging method is only recommended for people who can sell covered calls.
This is the preferred method for those of you with smaller portfolios that can’t afford 100 shares. Inverse (or short) ETFs are exactly what they sound like. They move inversely to the underlying asset, which is typically another ETF or commodity.
For the purposes of hedging your portfolio, I would recommend using an inverse index follower such as the Short QQQ (PSQ - Free Report) or ProShares Short S&P 500 (SH - Free Report) . These will provide a 1-to-1 inverse return from the underlying ETF.
Some investors would prefer to use leveraged inverse ETFs to hedge their portfolio with less upfront capital. Leveraged ETFs included 3x inverse QQQ (SQQQ - Free Report) and 3x inverse S&P 500 (SPXS - Free Report) .
Be careful with the leveraged ETFs as they decay over time, meaning that they lose value daily. These are not “buy and hold” assets but rather short-term trading tools. So if you do decide to get into one of these leveraged shorts, make sure you don’t hold for much longer than a week, especially if it’s not going your way.
The tools I discussed will help hedge your portfolio against further downside risk, with each of them doing so in a unique way. I am confident that we will retest our Monday lows soon, as this pandemic continues to advance and shudder the global economy.
Make sure you are prepared with a shopping list of your favorite equities and price levels you want to get in at. For ideas on what to shop for check out my article How To Play The W-Shaped Recovery.
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