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How Hedging Reduces Risk

Stocks are drifting higher in a environment of falling interest rates, trade deal optimism and "not as bad as we thought" earnings. It seems like it's smooth sailing higher from here.

The question on everybody's mind is: when will the market correct and head lower? The second question on everybody's mind is: what can I do to protect my portfolio?

There was a great article in Barron's this week that talked about these very questions. Investors are becoming more wary of the classic, 50/50 stock and bond portfolio because these days, stocks and bonds tend to move together and are highly correlated. The idea behind having both asset classes was that historically they tended to move in opposite directions. This provided some ballast so that when stocks were falling, at least bonds would be rising. Not so much anymore. Stock prices and bond prices are at all-time highs.

Diversification helps. There is value to having assets across the spectrum - cash, CDs, stocks, bonds, international markets, etc. But, when there's a severe downturn, just about everything will lose money. This is where hedging comes into play.

The basic definition of a hedge is this - to protect oneself against loss (on a bet or investment) by making balancing or compensating transactions. As one investment falls, the other goes higher in value. But what exactly are these balancing or compensating transactions?

Enter put options. Via Investopedia: "A put option becomes more valuable as the price of the underlying stock depreciates relative to the strike price." What that means is a put option goes up in value as the underlying asset goes down.

Here's an example:

October, 2018 was the start of a big downturn in the stock market. We didn't know it at the time, but indexes were set to fall between 10 - 18% in the next 3 months. Investor losses were huge. The market has come back since, so we tend to forget how painful these downturns were, but during the time, it was bad. Christmas eve was one of the worst days.

At the time, the market was at a peak, similar to now and investors had the same questions about a downturn and what they might do to protect against losses.

Put options were cheap because there was virtually no fear in the market. SPY, the most popular ETF in the market which tracks the S&P500 was sitting at all time highs.

An investor could have bought a put option on SPY (which goes up in value as SPY goes down) for around $675 per contract for an at-the-money put option, expiring in about 3-months. This means an investor was buying the "option" to sell 100 shares of SPY at 291 (even if SPY is at $200) for essentially 3-months of protection. Let's say realistically, an investor bought 10 contracts, which gives him or her the right to sell 1000 shares of SPY at $291 for 675 X 10 or $6500.

Yes, hedging or buying protection isn't free. This "insurance contract" lasting 3-months would cost $6500. Investors can design a hedge in many different ways with different time frames, but this example is common and works for simplicity.

Let's fast forward to the end of December. The $6500 put is now worth over $50,000. But, as with any investment, this put option's value fluctuates everyday. A wise investor would have sold it for a nice profit, or could have held to expiration and still made over $17,000. The chart below with the tan line shows the profit of the put as each trading day unfolded, with profit (in dollars) on the left highlighted in yellow.

This type of hedge would be appropriate for a $500,000 portfolio and it protected up to 10% of losses during this 3-month period, October - December 2018.

What's the downside of this type of hedge? Plain and simple, it doesn't work in UP markets. The idea is to buy protection for downside markets.

To be fair, let's run the same experiment, only this time buying $6500 worth of protection beginning October 1st of this year (2019). The market has gone up in October so we would expect this hedge to lose money, and indeed it has. The chart below illustrates this point. The put option is down over $3000. However, stocks are up overall so an investor would likely still be making money with a stock and bond portfolio. As well, this is a 3-month option so it could go up in value IF the market falls over the next couple months. There's also more fear in the market this year, so the put option is more expensive than last year so we would only get 7 contracts instead of 10 for $6500.

This is a true hedge. As the Barron's article put it, "Investors, big and small, should swap out some of their bonds for options strategies that reduce the risk of owning equities in ways that bonds should, but often fail to."

In other words, holding bonds does not hedge risk. Hedging reduces risk.

Options involve characteristics that are unlike stocks and bonds and they are not right for every investor. Investors should seek out a professional with expertise in the options market before transacting any options trades. Brockman Capital Management, LLC trades options on a regular basis so if you would like more information on hedging, please contact us.

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