Hedging for newbies

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PREPARED BY: Chris Stanford

DATE:5/19/22

Historically, US equities have shown resilience, leading many investors to focus on long-only portfolio exposure. However, in my 15-year investing career, I have learned the importance of hedging to navigate periods of market volatility. No one can consistently predict market tops and bottoms, and over time, everyone is likely to make significant mistakes. Successful traders understand the need to structure their ideas to protect against worst-case scenarios, and hedging allows for that flexibility. When implemented correctly, hedging transforms success and failure into a nuanced spectrum rather than binary outcomes.

UNDERSTANDING HEDGING

Upon analyzing investment portfolios, I often find that few people are actively hedging, and those who do often do it improperly. Many assumptions are made about which assets will protect portfolios, but these assumptions can be misguided. For instance, the expectation that Bitcoin would perform well due to inflation has been challenged, as the dollar has actually outperformed Bitcoin. Hedging involves using one or more assets to offset potential losses from other owned assets. While the concept may be familiar, the detailed understanding of how to execute effective hedging strategies may be lacking.

CHALLENGES INVOLVED WITH HEDGING

Implementing effective hedging strategies requires sophisticated analysis and execution. Many investors shy away from hedging because it can lower potential returns and act as a drag on portfolios during normal market conditions.

Another challenge lies in the changing behavior of traditional assets used for hedging. In today’s markets, there is a strong correlation among most asset classes during periods of stress. When things go awry, everything tends to sell off together as investors seek safety in cash. The whole point of a hedge is that it creates inverse performance to the asset or assets you are hedging against. Otherwise it just creates further unnecerssary complication. To make hedging practical, a more intelligent structure is necessary.This breakdown in historical relationships between assets necessitates more careful structuring of hedges.

Portfolio size is often a constraint for investors, as smaller portfolios may not have the resources to afford hedging. Options offer a cost-effective way to hedge portfolios, as they provide predictability and mitigate correlation issues. Hence why they play a key role in our overall portfolio protection strategy.

BEAUTY OF THE COLLAR METHOD

Options present an excellent vehicle for hedging because they allow investors to lock in prices for buying or selling stocks. Through options contracts, investors gain the right to buy or sell a stock at a fixed price over a defined period, regardless of how much the stock moves. By combining different types of options, it is possible to hedge a portfolio at little to no cost. The strategy is a bit complicated to explain in short form, but we discuss this in further detail within the Alpha University Options course framework.

FOCUSING ON EASILY HEDGABLE ASSETS

When considering hedging, it is beneficial to focus on assets with predictable trading behaviors and consistent performance. Judging consistency can involve evaluating standard deviation and modeling capabilities. Additionally, liquidity in the options market for these assets and reasonable pricing relative to the underlying asset are crucial factors.

GENERAL PRINCIPLES OF HEDGING

Certain general principles can guide effective hedging strategies:

Obtain insurance when it is cheap and undervalued.
Gradually reduce holdings as the Federal Reserve signals the end of a cycle.
Use backtesting software to understand how options perform under specific conditions.
Maintain flexibility to unload hedges easily, as provided by the collar strategy.
Avoid products that trade in over-the-counter (OTC) markets.
Develop a clear playbook with rules to avoid making arbitrary hedging decisions. Planning is imperfect, but having no plan can lead to disaster.
Conduct backtests and stress tests to identify downside scenarios requiring hedging.
Hedge against quantified outcomes rather than relying solely on previous trading data.

Incorporating these principles can enhance the effectiveness of hedging strategies, providing investors with better risk management and protection in their portfolios.