Hedging is a strategy designed to reduce the risk of adverse price movements for a given asset. For example, if you wanted to hedge a long stock position you could purchase a put option or establish a collar on that stock. Both of these strategies can be effective when dealing with a single stock position, but what if you're trying to reduce the risk of an entire portfolio? A well-diversified portfolio generally consists of multiple asset classes with many positions.
Employing either of the techniques above on every equity position in a portfolio is likely to be cost prohibitive. Another alternative would be to liquidate part of your equity holdings, which could partially offset the impact of a stock market decline. Most long-term investors, however, aren't comfortable moving in and out of stock positions, either because of the potential tax consequences or because they want to avoid having to time their re-entry.
What other alternatives are available for investors interested in hedging a portfolio? Portfolio hedging is considered an intermediate to advanced topic, so investors considering this strategy should have experience using options and should be familiar with the trade-offs they involve. Many investors have a long-term horizon and try to ignore short-term market fluctuations. However, hedging may make sense for tactical investors with shorter-term horizons, or those who have a strong conviction that a significant market correction might occur in the not-too-distant future.
A portfolio hedging strategy is designed to reduce the impact of such a correction, in the event that one occurs. A hedge is considered effective if the value of the asset is largely preserved when it is exposed to adverse price movements. Here, we're trying to hedge the equity portion of our portfolio against a market sell-off.
Therefore, the hedge should appreciate in value enough to offset the depreciation in portfolio value during the market decline. Ideally, the hedge would preserve the value of the portfolio regardless of the severity of the sell-off.
How much would you be willing to pay to hedge your entire portfolio for a certain period of time? Perhaps the answer depends on your belief in the likelihood of a significant market correction. In order to establish a true hedge on an individual portfolio it may be difficult, if not impossible, to find a single financial product that's perfectly correlated to your portfolio.
In the following example, we assume the equity portion of the portfolio has a constant 1. Of course, correlation will vary among individual portfolios. For this example, we are using the at-the-money strike price to obtain immediate downside protection in the event of a sell-off.
The table below illustrates how the value of the portfolio would be affected based on the performance of the SPX at the expiration of the three month SPX put options.
Schwab Center for Financial Research. There is no change in the value of the other assets in the portfolio. Data represents value at expiration. As you can see, this hedging strategy was highly effective, as the value of the portfolio was preserved in all scenarios. Because we purchased puts on an index that we do not own, we can't sell calls on that index without establishing a naked call position.
If you are not comfortable with selling calls on your stocks and you are still concerned with the cost, then this strategy may not be appropriate for you.
The hedging strategy presented above provides an efficient way to hedge an entire portfolio, but is the cost worth the benefit? Others may feel that establishing a short-term hedge is equivalent to timing the market and may therefore elect to focus on the long-term. Regardless of your opinion, gauging the likelihood of a significant market decline may be helpful. One way to obtain an approximate likelihood of various SPX price levels is to look at the Delta of the put strike prices that corresponded to the percentage decline levels.
Of course, the more severe declines are accompanied by lower probabilities, but this type of information may help you determine whether the cost of hedging a portfolio is worth it or whether you should ride it out. Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab.
Multiple-leg options strategies will involve multiple commissions. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.
Past performance is no indication or "guarantee" of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The information presented does not consider your particular investment objectives or financial situation, and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice.
Supporting documentation for any claims or statistical information is available upon request. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
Examples are not intended to be reflective of results you can expect to achieve. Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Any written feedback or comments collected on this page will not be published. Skip to main navigation Skip to content. You are here Home Options. Hedging isn't for everyone Portfolio hedging is considered an intermediate to advanced topic, so investors considering this strategy should have experience using options and should be familiar with the trade-offs they involve.
How do I select a hedge? Effectiveness and cost are the two most important considerations when setting up a hedge. All index options are cash settled, which makes the position easier to manage around expiration.
Now let's see how you might put a hedge to work. This figure takes into account the 0. This is the value of the puts at expiration How did I choose the hedge amount?
How does the VIX affect the hedge? What if cost is a concern? Is it worth it? Leave this field blank. Talk trading with a Schwab specialist anytime. Call M-F, 8: Important Disclosures Options carry a high level of risk and are not suitable for all investors.More...