Hedge in Investments

When you hedge your investments, you make a counterbalancing investment to offset the risk in another investment. Hedging makes the most sense if you have risky, short-term investments in your portfolio. Long-term investments should be able to ride out short-term market fluctuations. Hedging is an intermediate-to-advanced technique. If you're a beginning investor, talk to an experienced investment advisor.[1]

Steps

Diversifying Your Portfolio

  1. Own assets across all investment categories. There are many different categories of investments, including stocks, bonds, real estate, and international investments. Spreading your wealth across these categories helps protect your portfolio from volatility.[2]
    • If you invest in only one category, you are at the mercy of the movements of that particular sector. For example, if you have all of your investments in real estate and the bottom falls out of the real estate market, you could lose a substantial amount of money.
    • Balancing your investments across the board decreases your risk in specific categories simply because you have less invested. You can make up for a loss in one category with a gain in another.
    • Include cash in your portfolio for security and stability. If you're unsure how much of your assets should be in cash, talk to a financial or investment advisor.
  2. Hedge riskier investments with defensive assets. Consumer staples, utilities, and bonds are considered defensive assets because they tend to gain value when other stocks are losing value. Keeping a mix of them in your portfolio can help offset losses in a volatile market.[3]
    • Basic utilities and commodities tend to be resistant to most market fluctuations. People still need to eat and power their homes regardless of a downturn in the market.
    • Defensive assets have their own risks as well. For example, if you've invested in a particular crop or utility, you may suffer losses if there is a major natural disaster.
  3. Invest in low-cost index funds. Index funds offer an essentially passive way to hedge your portfolio. Because such funds track an overall index, they're a lot more stable than individual stocks.[4] You'll also save money on fees since they don't require active management.[5]
    • If you're a beginning investor or have a relatively small portfolio, holding shares in an index fund provides your portfolio with stability and helps shield you from risk.
    • Be aware, however, that investing in index funds will not lead to great riches. It's a safe, fairly reliable move that's not designed to generate huge returns.
  4. Buy gold for overall portfolio protection. Investment in gold and other precious metals is a tried and true way to protect riskier assets. Precious metals tend to rise and fall independently of other market factors, and gold often rises when stocks are falling or experiencing volatility.[6]
    • Exchange-traded funds (ETFs) are the easiest way to invest in gold and other precious metals if you are an individual investor with limited capital. You buy shares in these funds just like you would any other stock or mutual fund. These funds also have relatively low expenses compared to other methods of investing in gold.
    • Some examples of gold ETFs are the SPDR Gold Shares ETF (GLD) and the iShares Gold Trust ETF (IAU).
  5. Reduce your portfolio's volatility with fixed-income investments. Fixed-income investments are also known as bonds or money market securities. These are loans that you make to a corporation or to the government. In exchange, you are paid a fixed amount of interest until the investment matures, at which point the principal is returned.[7]
    • U.S. treasury bonds typically are considered the safest, but the rate of return may not be as high as other fixed-income investments.
    • On the other hand, junk bonds issued by corporations may generate more income, but they also have a much higher risk of default.
  6. Study university endowment portfolios. Private universities manage investments through their endowment portfolios. Information about these investments is available to the general public. Many universities, such as Yale, have high-performing portfolios that you can use as models.[8]
    • Focus on endowment managers at America's Ivy League schools, including Columbia, Harvard, and Yale. These portfolios have consistent returns and few losses.
    • These endowments tend to hold billions in investments, and may take advantage of tools that aren't available to you as an individual investor unless you have a sizable portfolio. A professional investment advisor can help you arrange your investments to mimic these portfolios.

Hedging with a Pairs Trade

  1. Identify the market sector. Using pairs trading to hedge your portfolio requires choosing two stocks in the same market sector. Stocks in the same sector typically rise and fall together, and are subject to similar risks.
    • For example, you might choose to invest in the oil industry. This would involve buying stock in oil companies such as Exxon (XOM) or Shell (RDS/A).
  2. Find two correlated stocks. Within your chosen market sector, look for two stocks that are closely correlated with each other and seem to move in sync with each other. Study the history of the two stocks and compare them to find their correlation.
    • For example, in the oil industry, Conoco Phillips (COP) and Shell (RDS/A) are closely correlated.
    • You can also use exchange traded funds (ETFs) in a pairs trading hedge. ETFs are funds that track indexes, such as the Dow Jones or the S&P 500. The same as with individual stocks, look for indexes that typically move together.[9]
  3. Choose your long and short. Pairs trading involves taking a long position in one stock and then taking a short position in another, correlated stock.The idea is that any loss in one position will be offset by a gain in the other position.
    • To continue the oil industry example, suppose you decided to go long with 25 shares of Conoco and use Shell as your hedge.
  4. Calculate the market value of your position. The market value of your position depends on the number of shares of stock you hold in your long stock and what that stock is currently trading at. Your value may fluctuate depending on how volatile the market is.
    • For example, if you held 25 shares of Conoco that were currently trading at $40 a share, the market value of your position would be $1,000.
    • To hedge the full market value of your position, you would need to short $1,000 worth of stock in Shell.
  5. Monitor for fluctuations. As the market moves, your stocks will go up and down. If your long stock performs better than your short stock in the long haul, you can reduce your risk.[10] In an ideal situation, you would potentially turn a loss into a profit.
  6. Use stop-loss orders on both positions to protect your investments. A stop-loss order protects you if the price of your stocks falls below a price you've chosen. If the stock falls to that price, the stop order becomes a market order to sell your sock before the price drops any lower.[11]
    • You will lose money with a stop-loss order, but the order protects you from potentially losing any more by getting you out of the situation.
    • The price at which you set your stop-loss orders depends on the size of your portfolio and the amount of loss you're willing to risk.

Using Options and Futures

  1. Consult an investment advisor. Options and futures are more advanced hedging strategies that can be challenging for beginning investors.[12] If you want to hedge your investments, your profile should be actively managed by a dedicated stock broker or investment advisor.[13]
    • Look for a licensed stock broker who has a solid reputation and plenty of experience managing portfolios similar to yours and larger.
    • Stock brokers who work at large brokerage firms may have more resources at their disposal to manage your portfolio, but they also may charge higher fees. Interview several brokers and compare to find the best fit for you.
  2. Buy protective put options. Protective put options are relatively versatile and allow you to protect significant investments without a lot of risk. For just a few hundred dollars, you can cover tens of thousands of dollars in stocks.[14]
    • Essentially, a protective put option puts you in the position of betting that the market declines. If the price goes below the amount in your option, you get paid.
    • For example, if you buy a protective put option for the SPDR S&P 500 ETF at 190 strike, it protects 100 shares if that index drops below $190. If the price doesn't fall below that number on the day the option expires, you don't have to do anything – but if it does, you can exercise your option and get paid the difference.
    • Protective put options will work best for you if you are a moderately sophisticated investor with a portfolio of significant size.
  3. Protect your portfolio with index puts. To fully hedge your stock, buy enough options contracts to cover the full value of your stock that correlates to the index. The value of your put options will rise as the market falls.[15]
    • To use index puts to hedge your investments, find an index that has a high correlation to the stocks you want to protect. For example, if you have a lot of technology stocks, you would want to look at the Nasdaq Composite Index.
    • You'll pay a price for each option contract. Your stock broker can finance these purchases by selling index call options at the same time using the index collar strategy.
  4. Hedge dependency on a commodity with futures contracts. Futures contracts are most valuable if you own a business that is dependent on a specific commodity. If that commodity becomes too expensive, you can use a futures contract to buy the commodity at a lower price.[16]
    • A futures contract allows you to buy a commodity at a set price on a future date. If the price of the commodity goes up, your futures contracts would provide a hedge against those higher prices.
    • For example, suppose you own a small coffee roasting company. Your business is dependent on coffee. A natural disaster or government crisis that disrupted coffee production could drive prices through the roof. A futures contract could help blunt the damage to your company and your bottom line.
    • The risk with futures contracts is that if the price of the commodity drops, you're still committed to buying at the price you set in the contract.

Related Articles

References

  1. ↑ https://www.schwab.com/active-trader/insights/content/how-hedge-your-portfolio
  2. ↑ https://www.nolo.com/legal-encyclopedia/how-diversify-investments-easy-rule-30216.html
  3. ↑ http://www.marketwatch.com/story/protect-your-portfolio-with-these-5-basic-hedging-strategies-2014-10-28
  4. ↑ [v161502_b01]. 16 July 2020.
  5. ↑ http://www.marketwatch.com/story/protect-your-portfolio-with-these-5-basic-hedging-strategies-2014-10-28
  6. ↑ http://marketrealist.com/2016/08/diversify-portfolio-gold/
  7. ↑ [v161502_b01]. 16 July 2020.
  8. ↑ https://www.forbes.com/sites/robrussell/2015/06/29/how-to-hedge-risk-in-your-portfolio/#2592943b5ad0
  9. ↑ http://etfdb.com/etf-trading-strategies/how-to-use-a-pairs-trading-strategy-with-etfs/
  10. ↑ [v161502_b01]. 16 July 2020.
  11. ↑ https://www.investor.gov/introduction-investing/basics/how-market-works/types-orders
  12. ↑ [v161502_b01]. 16 July 2020.
  13. ↑ https://www.schwab.com/active-trader/insights/content/how-hedge-your-portfolio
  14. ↑ http://www.marketwatch.com/story/protect-your-portfolio-with-these-5-basic-hedging-strategies-2014-10-28
  15. ↑ http://www.theoptionsguide.com/portfolio-insurance-using-index-puts.aspx
  16. ↑ http://www.investopedia.com/articles/basics/03/080103.asp
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