Using Hedging Strategies
In other articles, we discussed the best assets to invest in after a market crash. But what if you don’t want to wait for a market bottom – what if you want to develop a strategy that will enable you to actually profit from the decline? And what if you want to implement that strategy now?
Using hedging strategies, you can do just that. These are strategies that enable you to profit when certain stocks, markets or asset classes decline.
What Is Hedging?
Simply put, hedging is about employing strategies that enable you to make money when the underlying value of the asset in question falls. It is similar to insurance, except that it is insurance that you take out on a given stock, asset class, market sector, or even an entire market.
While it may seem that hedging is more pronounced during declining markets – and in general it is – it’s actually a process that happens all the time in investments. For example, mutual funds might employees hedging strategies in order to minimize volatility in their portfolios. There are even hedge funds established expressly for that purpose.
Stock market declines and crashes are when hedging becomes even more important. Down markets can make it difficult to find profitable investments anywhere, so finding ways to make money from the actual decline becomes the central goal.
There are various ways that you can hedge, and we’re going to look at some in detail.
Long Versus Short The Market
If you’re familiar with the concept of short selling stocks, then you have a basic understanding of what hedging is all about. You can then apply the same strategy to markets, asset classes, and industry sectors.
Being “long” on a stock is the traditional way to own it. You purchase the stock in the hope of selling it at a later date at a higher price and a large profit.
When you “short” a stock, you’re doing the opposite. You are actually selling the stock without even owning it. You do this by borrowing the stock from your broker. If the stock falls in price, you can then buy the stock from the broker which completes the transaction.
For example, let’s say that you have a strong feeling that the stock of ABC Corporation, currently trading at $50 a share, is heading for a fall. You short sell 100 shares of the stock for $5,000 by borrowing the shares from your broker. One year later, the price of the stock falls to $25 a share. You decide to close out your position, so you actually buy the stock from your broker for $2,500, and then close out your position for a $2,500 profit.
You can do the same thing with markets, industry sectors, and asset classes.
There is one limitation in shorting an asset, and it’s potentially huge. When you purchase a stock long, you have an advantageous combination of having limited liability in the event of decline (your investment in the asset), but unlimited profit. Taking the example of a $50 stock, if it wipes out completely, you’re out $50 on the stock. But if it rockets to $500, you have a 1,000% gain.
But that dynamic reverses when you go short. The amount of your gain is limited to the price of your stock, but your liability on loss is virtually unlimited. If you short sell a stock at $50, the most you can make on it is $50 – and that assumes that the stock goes all the way to zero.
But if the stock rises to $150 per share, you will lose $100, or twice your initial investment.
In reality, it’s never quite that bad. Since you borrow the stock from your broker, your broker imposes limits on how much you can lose. These are referred to as “margin calls”, since short sales are typically purchased on margin. You will usually be required to put up a minimum of 50% of the value of the transaction in cash, however should your equity position fall to below 30%, the broker will execute a margin call, forcing you to provide more cash or to liquidate your position at a loss.
Naturally, shorting any asset should work better in declining markets then they will in rising markets.
Another way to hedge your investing is to use options. An option is a contract sold by one party – the option writer – to another party – the option holder. The buyer/holder has the right, but not the obligation, to either buy or sell the security at an agreed-upon price, which is referred to as the “strike price”. There is a certain period of time to execute this option, or there may be a specific date on which the option must be exercised.
The right to buy a security is referred to as a “call”, while the right to sell is referred to as a “put”.
Since put options provide the option to sell at a certain price, the buyer profits when the stock goes down. For example, if a put gives an investor the right to sell a stock is $50, and the price of the stock falls to $30 before the option expires, the investor can buy the stock at $30, and then sell it for $50, leaving a $20 profit.
You can take put options on stocks, but if you feel uncomfortable doing this yourself, you can also invest in exchange traded funds (ETFs) that do it as part of their investment strategy.
Using Inverse ETFs
Inverse ETFs are exchange traded funds that are centered on profiting from the decline in the value of a certain benchmark. They use certain derivatives that enables this to happen. It enables an investor to short an entire portfolio of stocks, rather than to do it on a one by one basis.
One of the primary benefits of using inverse ETF’s is that you do not hold your investment position in a margin account the way you would if you are shorting individual stocks. The absence of margin limits your leverage, and therefore your downside risk. You will earn investment returns on the fund that are commensurate with the declines of the underlying index.
Inverse ETF’s can bet against an underlying index, such as the Dow Jones Industrial Average, the S&P 500, the Russell 2000, or even an index that is based on various industry sectors. You can invest in an inverse ETF covering any market which you believe is overpriced and due for a fall. In that way, you can profit from the decline.
A major negative obviously is when the underlying securities or index rise in value. When that happens, you will lose money in an inverse ETF.
Leveraged ETFs vs. 1x Inverse
A variation of an inverse ETF is a leveraged ETF. An inverse ETF correlates gains and losses to changes in market value of the underlying index on a one-to-one ratio. But there are leveraged ETFs that use debt to increase that ratio to 2:1, which is commonly expressed as “2x” or “-2x” since it is an inverse arrangement. That is to say that the fund will gain at twice the loss of the underlying index.
The downside is that gains in the underlying index will also result in losses in the inverse ETF that are twice as great as the index gains. In this way, a 2% increase in the underlying index will translate into a 4% decrease in your investment in the inverse ETF.
This is similar to the situation with shorting stocks, where your gains are limited to your investment, but your losses are unlimited – at least theoretically.
Still, if you believe that the underlying markets are overvalued and due for a fall, leveraged ETFs may be a good place for at least some of your money. Just make sure that it’s a minority percentage, and that you’re covered by more traditional investments.
Here are examples of inverse ETF’s. All are available through ProShares, are set up to be the inverse of popular indexes, but none are leveraged.
ProShares Short S&P 500 (SH). This fund is a large cap hedge that shorts the S&P 500 index. That is, it seeks investment results that of the inverse of the performance of the S&P 500 index. It should position you well for a general market decline.
ProShares Short Dow 30 ETF (DOG). This fund is a blue chip hedge. It shorts the Dow Jones Industrial Average 30 stocks.
ProShares Short Russell 2000 ETF(RWM). This fund is a small cap hedge, that shorts the Russell 2000 index.
ProShares Short QQQ ETF (PSQ). This fund is a hedge for the technology sector. It seeks investment results that correspond to the inverse of the performance of the NASDAQ 100 index. Meaning that when the technology sector loses, you win.
Once again, these funds can represent a minority percentage of your total portfolio. While that can enable you to profit from a general market decline, they can also work against you if the market decline doesn’t materialize, or worse, if the market goes on another bull run.
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While Dual Returns has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.