Strategies Used to Hedge Your Portfolio
By: Don Wellenreiter
The following is an excerpt from Don Wellenreiter's Millionaire Secrets for the Average Guy
The practice of hedging simply involves the use of options (or futures) with pre-existing or planned stock market investment to offset the change in value of the equity position by the performance of the options positions.
Synthetic Futures Position
A synthetic position refers to both the buying of a call and selling of a put; or the buying of a put and the selling of a call. For our purposes here, we are discussing how to hedge a portfolio, so we will only focus on the buying of a put and the selling of a call. This type of strategy is used in lieu of selling a futures contract short. Depending on your outlook for the stock market you would sell a call at, near, or out-of-the-money. You should calculate what reasonable gain you would accept in your portfolio to decide where you would sell the call.
As an example, with the December 1998 S&P trading near 1124 after beginning the year at 1010 (a year to date gain of just over 11%), you may decide that you would be willing to lock in gains of 22% on the upside, 3% on the downside. To accomplish this you could sell the December 1998 1240 call for 2060 points ($5,150) and buy the December 1998 1040 put for 3850 points ($9,625). This debit to your account would cap your gains for the year around 22%, while locking in a 3% gain for the portfolio. It is important to remember that the call option that you are selling will require you to have enough funds available in your account for margin purposes.
“Free” Protection
Here we will continue to use the S&P 500 for example purposes. Let’s say that you own a portfolio that resembles this index, and your annual dividend yield is currently around 1.6%. A 1.6% dividend on a $275,000 portfolio equates to $4,400 a year. You can then take the dividend proceeds and purchase an out-of-the-money put to protect your portfolio. This is the same thing that many of the stock fund managers have done to protect their holdings. With the $4,400 you could go out to the December 1998 contract for the S&P and purchase a 920 put at not cost to you! This would allow you unlimited upside potential while still protecting the majority of your gains.
Hedging with Futures
We would be remiss if we didn’t touch on the subject of hedging with futures contracts. There are advantages and disadvantages to each of these strategies, and you must be the final judge as to which is most appropriate for your own needs and market outlook.
If you believe that the market is very close to beginning a correction, you could sell a futures contract (the number of contracts sold will depend on your portfolio’s beta), while still being fully invested in the stock market. If the sell-off does occur, the short futures contract would be gaining as much as your stocks are falling. Once you have decided that the market has bottomed, you would then buy back your short futures and wait for the rally to lift your stocks back up. Of course, you could just hang on to your futures until the market rebounds back to the point you originally shorted the market and then take your protection off.
If you are incorrect about the market’s direction and the market never breaks down and continues up, your portfolio would neither increase nor decrease in value, as your short futures will have neutralized any gains your stock might have made.
If the market remains the same, you would not experience a loss or gain, as your stock and futures position would be essentially flat. This is one of the benefits of the futures hedging strategy versus the straight put option purchase. The options would have expired worthless, reflecting a loss in your portfolio, while the futures position would have no net (or very little) change.