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Thursday, December 22, 2022
Hedging your portfolio: Tips to keep in mind
By Century Financial in 'Blog'
When we hear hedging, we often think of it as an esoteric term, often used by traders or investment planners. But in reality, it isn’t, and even if you are a beginner, you can learn it and see how it works for your benefit.
As a strategy, hedging is all about attempting to limit risks in financial assets by using financial instruments or market strategies to offset risks of price movements. In simpler words, investors protect their investments by making another trade.
In the stock market , any investment is vulnerable to market risks or price fluctuations. That is why hedging is a perfect way to reduce risk. Remember, protecting your portfolio is as important as watching your portfolio grow.
How to find a suitable hedge for your portfolio?
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Well, there is no way to choose what best works for your investments, but you can look at your portfolio and consider the pros and cons and make an informed choice. So here are some basic questions you need to ask yourself
• How much of your portfolio do you need to hedge?
• Where are the majority of my investments?
• What is the average beta of the stocks I hold?
• How much upside am I willing to forfeit?
• How much will it cost?
Once you are certain you want to hedge, you must consider the costs involved. Remember, hedging stocks with options require paying premiums, and they depend on several variables like
• Current price of the underlying instrument
• Strike price
• Current interest rate
• Time to expiry
• Expected dividends
• Expected volatility
After you have an idea of the costs involved, consider the various strategies and whether the protection is worth the costs. If they do, here are some of the ways you can hedge your portfolio.
Long-put position
A long-put position is probably the easiest hedge to pull off. But also the most expensive. Here, a strike price of 5% or 10% below the current market price is utilized for the option and will not safeguard your investment till the index declines to the first 5% or 10%.
Collar
Here you purchase a put option and sell a call option. When you sell a call option, a portion of your cost is covered on the put option. So when the index goes beyond the price of the call option, it will result in losses but will be offset by gains in the portfolio.
Covered call
In this strategy, a trader sells out-of-the-money call options against a long equity position. Generally used on individual stocks, this strategy doesn’t necessarily reduce your downside risk; however, the potential losses are offset due to the premium earned.
Diversification
It has been said a million times, but diversification remains one of the most efficient ways to hedge your portfolio. So keep it simple, and hold stocks as well as debt, alternative assets and saving instruments to reduce your portfolio’s overall volatility.
Short selling
Another cost-effective way to hedge is by short selling stocks or futures. When you sell and repurchase a stock, there is an impact on the price of a stock. However, there is very little impact when you trade futures. In fact, it is a lot cheaper and more efficient to sell a futures contract to reduce equity exposure.
Buying volatility
This here is another excellent way to hedge your investments. As an index, the VIX index is implied volatility for various S&P options. In the active market, you are likely to find futures based on the VIX index, including ETFs and options. And when the market corrects itself, which it typically does, these instruments increase in value when the long position losses its value. So when you purchase volatility ETFs at a time when the VIX are at low levels, you have found an effective hedge.
Using CFDs
Another effective way to hedge your investments is through a contract for difference (CFD). For example, say you have both a share in a company, but you are concerned the prices could drop, it would make sense to open a short position on a CFD on the same share, thereby holding both at the same time. Thus, if the prices move up, you make money in your long position while making losses in your CFD and vice versa.
The simple truth is that in wealth creation, risk is an essential element. Therefore, regardless of the type of investor, you plan to be, having an understanding of hedging strategies will help you in the long run.
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