How to Effectively Hedge Your Stock Portfolio

Fajasy
Updated: April 10, 2022

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In this article, I will show you how to effectively hedge your stock portfolio. Put simply, hedging is the insurance of investing. Therefore, the purpose of a hedge in a portfolio is to move in the opposite direction of another asset in your portfolio, preferably at a delta of negative one (to represent negative correlation). By properly hedging your stock portfolio, you're protecting yourself against anything that could happen in the future, thereby further minimizing the downside risk of your stock portfolio.

When investors hedge their portfolio, they're reducing or eliminating certain risks that can impact their holdings. These risks include stocks or industries experiencing a decline, rising interest rates, inflation being higher than expected, commodity risk, currency risk, and more. Regardless, one hedges their portfolio because of stock market crashes as a whole. No one knows when the next market crash will be, they can only guess. Therefore, because it's impossible to time the market, investors can hedge their portfolio instead to protect it from whatever happens in the future.

Diversification

The key to effectively hedging a stock portfolio begins with diversification. Diversification refers to the process of allocating assets, risks, and investments across multiple business entities or industries. When a portfolio is properly diversified, it will reduce the downside risk of an investment portfolio, and give investors the chance to take advantage of a variety of different asset classes that may perform differently in different markets. Being properly diversified can therefore limit the necessity of excessively hedging one's portfolio in times of high market valuations.

Many mistakenly assume diversification to be just owning an index fund that tracks the S&P 500 (e.g., the SPY). However, this is not really diversification, as you're largely only being exposed to large equity U.S. stocks. The market failing to perform well over certain periods clearly exposes this fact. Similarly, just owning the S&P 500 and the aggregate bond index (AGG) is also not proper diversification, as the performance of these asset classes are highly dependent on interest rates.

To achieve proper diversification and to hedge your downside risk, one effective method is to build an "All Weather Portfolio," as Ray Dalio teaches. With an All Weather Portfolio, you'll typically be generating an above-average long-term return while reducing your downside risk exposure.

For reference, the All Weather Portfolio asset allocation is shown below:

Achieving diversification can also be as simple as reallocating your portfolio. For example, if your portfolio is heavy in technology stocks, allocating more of your portfolio to defensive sectors may reduce your downside risk if the market were to crash. Investors can always look into different investment asset classes beyond the stock market as well.

Cash

Cash can be thought of as a type of hedge. If you're afraid of a market pullback and think the market will crash tomorrow, you may sell all of your positions and hold cash instead. In theory, when the market falls, you can deploy this cash to purchase stocks at a cheaper price and profit more over the long-term. Granted, holding cash forfeits any upside potential because you're no longer invested in the market. However, you also have no downside risk because you're not invested in the market. From this perspective, you can see how cash can be classified as a "perfect hedge."

In general, liquidating your investments to hold more in cash is not recommended. Not only is this timing the market, but you'll be subject to taxation on any short or long-term holdings. If these investments included dividend-paying companies and/or fixed income, then you’re giving up dividend income and/or interest as well. Moreover, this cash will sit there and do nothing, slowly losing value over time due to inflation.

Regardless, cash should have a place in your portfolio, especially when the market appears overvalued and many indicators point to an upcoming recession and/or market crash in a sector you're looking to invest in. If market valuations appear very overvalued, you may want to hold up to ~20% of your portfolio in cash. If valuations appear undervalued, you may want to only hold ~5% in cash and re-balance your portfolio accordingly.

Although cash is powerful on its own, keep in mind that it’s not a reliable hedge. More importantly, cash can be more useful when deployed to purchase one of the other hedges discussed in this article.

Gold, Silver, and Cryptocurrency

Gold, silver, and cryptocurrency are all alternate investment assets that are limited in quantity, provide uncorrelated returns to equities, and have varying levels of portfolio hedging viability/potential. Therefore, I've grouped all three asset classes into this section.

Gold

Gold is a store of value that generally provides uncorrelated returns to equities. However, this does not mean that gold should be thought of as an effective hedge against the market. At most, gold should be thought of a store of value that when bought at the right time and allocated properly in a stock portfolio, can be considered a semi-useful hedging instrument against the stock market.

Gold's historical performance versus the S&P 500 since 1950 can be seen in the chart below, on a linear scale:

To better understand whether gold is valuable as a portfolio hedge, I analyzed correlated returns for gold prices vs. the S&P 500 for the three most-recent recessions in the U.S. stock market. In short, over six different periods across these three different recessions, gold correlations ranged from having a negligible correlation (e.g., best-case of -0.12 during the Dotcom Recession) to a medium-strong correlation (e.g., worst-case of 0.75 for the COVID-19 Recession).

In theory, investors will retreat to gold when market fears are high, which can help reduce portfolio downside risk. On the contrary, according to past performance, gold prices appear to be largely speculative and unpredictable. Additionally, they were only consistently valuable as a hedge if they consisted of 10% (not always 5%) of an S&P 500-only portfolio for the Dotcom Recession and Great Recession, but not as much during the COVID-19 Recession.

Regardless, holding 10% of your S&P 500-only portfolio in gold for all three market scenarios appeared to maintain your portfolio value or improve it by a certain amount, which practically means that holding gold in a portfolio can be considered as a viable hedging instrument against the stock market. For example, allocating 10% of your S&P 500-only portfolio into gold from December 1, 2007 to June 29, 2009 would've increased the value of your portfolio 8.7% ((($6843.37 / $6297.32) - 1)*100).

However, considering the lost equity compounding from taking a 10% stake in gold, the reduced capital gain and dividend potential in purchasing stocks at a discount with cash during a market pullback, and the higher short-term tax consequences (as high as 28%) for selling gold ETFs, allocating towards gold in a market pullback appears to be not-as-valuable as a stock market hedging strategy as it may otherwise seem.

Silver

Silver is another monetary metal and is considered by many to be a "poor man's gold" asset class. In comparison to gold, silver is significantly cheaper per ounce but also more volatile. Additionally, since 2012, silver has had a correlation with gold at around 90%, and therefore can be thought of similarly in respects to its value as a hedging instrument. However, according to Morgan Stanley, silver may provide a better inflation hedge, given the greater industrial demand silver has over gold. Therefore, given a greater inflationary market, silver may provide to be the better hedge over gold.

The chart below compares historical Gold and Silver (CFD) price performance, and the correlation between the two precious metals is easy to see:

Cryptocurrency

Much like gold, cryptocurrencies generally provide uncorrelated returns to equities, and can therefore be seen as a type of "digital gold."

Bitcoin (BTC) is the largest cryptocurrency by market cap. Research from the University of Western Australia published in September 2021 concluded the following on Bitcoin as a portfolio hedge:

"Indeed, we show that for extreme levels of volatility, Bitcoin does not reduce the risk if added to a benchmark equity portfolio. This is not only true on average but also holds for sub-samples, including the COVID-19 crisis period. We conclude that a focus on correlations is not sufficient for extreme levels of volatility."

- Baur, Dirk G. and Hoang, Lai T. and Hossain, Md Zakir, Is Bitcoin a Hedge? How Extreme Volatility Can Destroy the Hedge Property (September 18, 2021).

Given this research, hedging a S&P 500 portfolio with Bitcoin would not be recommended. However, as the research paper also discusses, Bitcoin may act as a viable hedge against a portfolio with a similar/higher risk profile than Bitcoin:

"However, any asset that is more risky that the S&P500 has the potential to lead to a result where Bitcoin can diversify and hedge the risk. Most commodities, including oil and gold, emerging market stocks and stock indices, are more risky and thus are more likely to allow Bitcoin to diversify and hedge risk to a greater extent than for lower risk assets such as the S&P500."

- Baur, Dirk G. and Hoang, Lai T. and Hossain, Md Zakir, Is Bitcoin a Hedge? How Extreme Volatility Can Destroy the Hedge Property (September 18, 2021).

In short, given the extreme volatility and uncertainty of Bitcoin, hedging one's portfolio with Bitcoin (or any cryptocurrency) as opposed to gold or silver is certainly a more speculative move.

Volatility Index

The Volatility Index (the VIX) is a real-time market index created by the Chicago Board of Exchange (CBOE) that tracks the 30-day implied volatility of the S&P 500 Index, using options as inputs. The VIX is a forward-looking indicator of market volatility that is commonly known as the "fear index," and although it cannot be directly traded, investors can trade ETFs, ETN, futures, and/or options to gain direct exposure to the VIX.

The VIX can be thought of as a valuable market hedge, because when the VIX is relatively high, there is greater fear and uncertainty and the market. This "greater fear and uncertainty," as historically proven, only increases as the market continues to fall, which only makes the VIX all the more valuable as a hedging instrument.

Much like the gold article above, I analyzed correlated returns for the VIX vs. the S&P 500 for the three most-recent recessions in the U.S. stock market. In short, over six different periods across three different recessions, the VIX and the S&P 500 always had moderate negative correlations (e.g., worst-case of -0.62 during the Dotcom Recession ) to very strong negative correlations (e.g., best-case of -0.89 during the COVID-19 Recession).

Therefore, although the strategy is tailored to more sophisticated investors, gaining exposure to the VIX can be a valuable hedging strategy. However, investors who trade the VIX should always remember the two following items:

  • The VIX must be traded over the short-term as holding the VIX over the long-term is often a losing strategy. Therefore, you must consider the short-term tax implications of trading the VIX.
  • No tradable asset can currently track the VIX 100% accurately. In my article above, I found that the VXX captures just 38.48% of the daily move in the VIX (this is based on daily adjusted closing price data between the VIX and the VXX from January 25, 2018 to August 31, 2021).

Regardless of these downsides, holding even 5% of your S&P 500-only portfolio in the VIX (e.g., through buying the VXX ETF) can provide quite an effective hedge against the market falling. For example, allocating just 5% of your S&P 500-only portfolio in the VIX from February 20, 2020 to May 29, 2020 would've increased the value of your portfolio 4.8% ($9457.66 / $9024.91) - 1)*100). Given, this is under the assumption that you gain exposure to the VIX prior to the market falling (typically when the VIX is below ~20).

VIX and Market Corrections

The one-month (VIX) futures can be compared to the three-month (VIX3M) VIX futures, to better analyze the level of fear/panic in the markets, and determine when to best enter and exit a hedging position.

The VIX and VIX3M chart comparison is shown below:

If the VIX (30 days) is greater than the VIX3M (90 days), this means the expected volatility over the next 30 days is greater than the expected volatility in the next 90 days. This is abnormal, as there's typically more uncertainty in 90 days than there is in 30 days. However, when the market goes in "contango," the VIX will trade at a higher volatility than the VIX3M. Besides the VIX spiking itself, this is another sign of greater market uncertainty. Investors can therefore compare these two charts to evaluate whether to enter into a hedge position or not.

In specific, it's best to enter into a VIX/hedge position in a bear market when the following are true:

  • VIX is in contango
  • VIX3M/VIX ratio is below ~1
  • VIX > VIX3M
  • VIX < ~15-20

Exiting the VIX or a portfolio hedging strategy should be done when the VIX peaks for a few days (roughly) before the market itself bottoms. Therefore, when you see the VIX fall from what appears to be its peak, yet the markets are still falling, this is a sign that the market is near or at the bottom.

In specific, it's best to exit (and trade) a VIX/hedge position in a bear market when the following are true:

  • VIX breaks 30-40: Sell 50% of the VIX position. Buy the market dip.
  • VIX breaks 50-60: Sell the entire (other 50%) VIX position. Continue buying the market dip.

Clearly, your trading strategy here can vary, but this is the general outline to follow. Ultimately, this strategy should help you understand when to enter and exit portfolio hedging strategies (to limit your downside risk), whether it be through gaining exposure to the VIX or by trading options, as discussed below.

Options Hedging

Before considering options for hedging your stock portfolio, you should consider other portfolio hedging strategies first, as they are generally the easiest, least-risky, and least-costly to deploy. These strategies include holding more of your portfolio in cash (a "perfect hedge") and reallocating to defensive assets (e.g., fixed income, defensive sectors, stable dividend-paying companies, and gold), as previously discussed in this article.

However, if you expect a market correction to be greater than 5-10% (roughly), and/or if these alternative options have been exhausted or are not available to you, and/or if you own stocks/ETFs and do not wish to sell any of your holdings to re-allocate your portfolio (i.e., due to capital gains tax, loss in dividends, etc.), then you can use options as a way to hedge your portfolio.

In general, hedging your portfolio with options is typically done by buying put options on a broad-based index (ETF or Index). As the market falls, the value of these puts will continue to increase, which will offset your portfolio losses. Put options can therefore be considered the closest thing you can get to insurance for a security. However, hedging with options can be classified as an "imperfect partial hedge," because you'll never be protecting your portfolio dollar-for-dollar. The only feasible way to do this, is to move all of your assets into cash, which comes with its own downsides, as discussed previously.

Now, to better understand how options can be used to hedge your portfolio, I've broken it down into seven steps. Following these seven steps will help you evaluate which options hedging strategy to execute, if any, and will provide you with a more comprehensive understanding of how to actually execute an options hedging strategy.

Step #1: Evaluate Stock Market Decline Probabilities

Before you even begin hedging a portfolio with options, it's crucial that you understand and evaluate the probability of a stock market decline occurring.

The table below shows the different percentage stock market declines, the average frequency of each decline, and the average length of each decline:

Source: RIMES, Standard & Poor's
* Assumes 50% recovery rate of lost value
** Measures market high to market low

As you can see, the probability of a 10% or more decline in the S&P 500 in a single month is very low. As recommended earlier, a 5% decline is generally the bare-minimum threshold to even consider buying a put options hedge. This is because anything less than 5% is typically not even worth the cost of a put option itself. Therefore, only buy a put option if you have strong reason to believe the market will fall 5-10% or more within the next ~60 days. Reasons for this can be a prolonged inverted yield curve, the VIX and VIX3M/VIX ratio market correction signals (as outlined above), market uncertainties due to news, and more.

Step #2: Consider Alternate Hedging Choices

If you're not confident in the market falling more than 5%, then you can opt into doing the following (as consistent hedging is not cost-effective):

  • Assuming you have a well-diversified portfolio, doing nothing whatsoever.
  • Investing into one of the other non-options hedging strategies discussed in this article.
  • Sell (Write) Covered Calls: This will be most-beneficial when the underlying stock trades sideways.
  • Sell (Write) Call Credit Spreads: This limits losses and caps profits.

These last two options strategies are particularly useful strategies if you want to collect option premiums and generate additional income, without having to pay a relatively expensive option premium on put options. This is especially the case given that significant market corrections (over 10%) happen only about once every year.

Other Derivative Hedging Instruments

More sophisticated investors can also consider the two following derivative hedging instruments discussed below to hedge their equity portfolio:

  • Reverse Collar or Fence Strategy: This options strategy is a relatively lower-cost defensive strategy used to protect a position from decline while also sacrificing potential upside profits. In short, a fence combines a collar and put spread. Collars entail buying a put option and selling a call option. Put spreads consist of long and short put positions.
  • Short Futures Contracts: Shorting a futures contract provides a cheaper means to efficiently reducing equity exposure, while effectively keeping a cash position without actually having to move into cash. Granted, this comes with higher risk than just buying options, as you'll lose whatever you gain in your portfolio if the market continues to climb (as there's no optionality with futures).

If these alternate hedging choices are not ideal, implementing a long-put position is a relatively simple, valuable, but expensive options strategy to effectively hedge one's equity portfolio.

Step #3: Decide Which Index/ETFs Correlate Best to Your Portfolio

To effectively hedge using options, you must find an index that is closely correlated to your portfolio. A few index options are listed below:

  • FTSE 100 (FTSE)
  • Dow 30 (DJX)
  • S&P 500 (SPX)
  • Nasdaq 100 (NDX)
  • Nasdaq 100 Micro Index (XND)
  • Euronext 100 (XPAR)

If you have a very well-diversified portfolio, the easiest option may be to simply trade options on the S&P 500 Index (SPX). Granted, you can always select multiple indices if you'd like to be more sophisticated in your approach as well.

One thing to note here is that many broad-based index options (such as the ones listed above) are considered "1256 contracts" and therefore have favorable capital gains tax treatments. For instance, if you were to trade options on the SPX, then 60% of your gains will be taxed at the lower long-term capital gains rate, while 40% will be taxed at the ordinary (short-term) tax rate. Using current tax rates, this mixtures produces a max 26.8% tax rate. See the table below for details:

Internal Revenue Service (IRS): Section 1256 Tax Rates vs. Ordinary Tax Rates (2022 Rates)

When you're putting on a hedge, you're almost never going to hold onto the position for more than a year. Therefore, you have a slight tax advantage when you're trading index options, as opposed to trading options on most ETFs, which could be taxed up to 37% for short-term gains.

Index options also provide more flexibility in sizing (e.g., XND). You can also just sit on a index put option to expiration and this will be credited to your account in cash. On the other hand, if you own an ETF put option, you're likely going to have to figure out how to exit your positions, otherwise you may have to resort to effectively closing some of your stock positions if you don't close out the trade before the expiration date. Clearly, trading options on an index as opposed to most ETF options is a less complex and more tax-efficient option.

Step #4: Calculate Portfolio Beta and Portfolio Size

Beta is a measure of a security's volatility in relation to the overall market. A higher beta portfolio will require a larger hedging position, if you're looking to hedge as much of your equity portfolio as you can. Calculating portfolio beta can also help you determine which index/ETF option to trade.

Depending on the investment brokerage you use, portfolio beta can sometimes be provided to you. Regardless, if you need to calculate portfolio beta, follow the four steps below:

  1. Find the value of your entire portfolio (current share price multiplied by the number of shares for each stock). Typically, most investment brokerages provide this value to you.
  2. Calculate how much you have of each stock as a percentage of your overall portfolio.
  3. Multiply these percentage figures by the stock's beta (β) value. Investor's can use Yahoo Finance to quickly find stock beta for free.
  4. Sum the weighted beta numbers to get portfolio beta.

After you find portfolio beta, you can use the formula below to get your true portfolio size from a volatility perspective:

True portfolio size = Portfolio beta * Total portfolio value

For instance, if your portfolio beta was 1.2 and your total portfolio value is $500,000, then your true portfolio size is $600,000 ($500,000 * 1.2). Therefore, a full hedge on your portfolio would actually require a nominal value of $600,000.

Step #5: Understand Put Option Contracts

A put option is a derivative contract that gives the buyer (aka the investor) the right, but not the obligation, to sell an underlying security at a specific price (called the strike price), on or before a given date. The buyer of a put option acquires the right to sell 100 shares of stock at a certain price, as long as it's done by the expiration date. In exchange for buying these shares, the put option buyer pays the put option seller (aka writer) a fee (called the premium). This premium is for the option seller to keep, regardless of what occurs in the future.

A visual representation of a long put option at time of expiration is shown below:

| Stablebread
Long Put Option | StableBread
Protective (Married) Puts

If you combine your portfolio with a put hedge, what results is what's known as a "protective put." While a put option is a type of option contract, a protective put is a portfolio strategy that uses a put option in combination with the underlying shares you already own in your portfolio.

With a protective put, you're buying insurance on 100 or more shares of a security you already own. In the case that you don't own 100 or more shares of a security, but you want to buy the security and also buy insurance on the security, the option contract is no longer considered a protective put but rather a "married put." Therefore, with a married put, you're buying 100 or more shares of a security and the put at the same time, whereas with a protective put, you're only buying the put as you already own 100 or more shares of the security.

The protective (married) put option chart at time of expiration is shown below:

| Stablebread
Protective (Married) Put Option | StableBread

To explain this chart, if the markets continue climbing higher, you're still participating in this unlimited profit potential. The only thing you lose is the cost of the put option (the "premium"). If the markets continue to fall, the losses in your underlying portfolio will be offset by the increase in the value of the put option.

Protective (Married) Put Option Example

To demonstrate how buying a protective (married) put works using real market information, follow the example and three possible scenarios below.

In this example, I will buy a protective put option on the SPY, that is currently trading at $464.58 (on January 16th, 2022). The details of this put option contract are below:

  • Buy one put contract on the SPY (for 100 shares) that expires on April 14th, 2022 (88 days out)
  • Strike price: $450
  • Cost (premium) of put contract (maximum possible loss): $11.72 * 100 shares = $1,172
  • Maximum possible loss: -$2,630 (($1,172 + $46,458) - $45,000)
  • Maximum profit: Infinite
  • Break-even point: Above $476.30 ($464.58 + $11.72)

The table below shows how hedging would affect your put option value upon the expiration of the 88-day SPY put option (on April 14th, 2022), given different percent changes to the SPY:

Note: You can use OptionStrat to model this, and other option trading strategies yourself.

As you can see, with a protective (married) put, although your portfolio value still declines if the security's price were to fall, the value of the put option will continue to rise. This will help offset the unrealized losses in your stock portfolio, given the break-even point (B.E.P.) is reached. If the security continues to rise, then your upside potential is still unlimited, but you'll have to pay the option premium regardless.

If you do not expect the security to reach the break-even point or appreciate in value greatly over the short-term, then the put option contract is possibly not worth buying, as you'll be losing more from just the cost of the put option premium cost (ignoring commissions as well). Otherwise, buying protective (married) puts can be a valuable hedging strategy for your portfolio.

Step #6: Select Expiration Dates

To best execute a put option, you should understand that the cost of a put option depends on how far out the expiration date is. This is known as time decay, or "theta," which gradually decreases the value of the contract's premium. In general, shorter-term options are cheaper than longer-term options, but this comes with a tradeoff as shorter-time options lose value at a quicker rate. This is because shorter-term options are more sensitive to shorter-term movements, and therefore will have a higher "delta."

If you're hedging a smaller pullback of 3-5%, you should buy more short-term dated options (e.g., 1-2 weeks). This is how you maximize what's known as "gamma" (which measures the rate of change of an option's delta). Shorter-dated options therefore work when you're looking to protect against small pullbacks in the market that are understandably more frequent that larger pullbacks. This is where the other options or hedging strategies discussed prior can be implemented as well.

On the other hand, if you're hedging a larger pullback of greater than 5-10%, you should buy a longer-dated option (i.e., > 2 months) to minimize "theta decay." This is not only more cost-effective, but provides the best hedging value if you select long-term put options with a low strike price.

Long-term options can also be "rolled forward." This refers to the practice of closing an existing option position and opening a new position for the same option type at a higher strike price to extend the expiration date. Therefore, when you roll over put options, you can keep your strike price close to the current price. In theory, this would help keep the individual puts cheaper while remaining hedged.

Step #7: Select Strike Prices

To cover any major downside correction, you should buy out-of-the-money (OTM) puts with a delta between 30-40. Generally, this should be between 1-3% of your true portfolio size. Because the put option is OTM, the strike price will be lower than the market price of the underlying asset. The downside to this strategy, is that if the market does not fall significantly, then you'll actually lose more money in addition to the unrealized losses in your portfolio.

To provide a more comprehensive type of insurance that will cover any type of downside correction, you should buy in-the-money (ITM) puts with a delta between 50-60. Generally, this should be between 3-5% of your true portfolio size. Because the put option is ITM, the stock price will be below the strike price. Although this option strategy can be more expensive to deploy, in many cases it typically has a better outcome.

As a final note, if you decide to purchase put options, you should do so on relatively lower-volatility days. In general, higher volatility is equal to more expensive option prices. Therefore, if you're buying a put option while the market is already crashing, it's likely going to be a much more expensive purchase. To avoid paying more, you can watch the VIX Index, and if it dips lower, you may be able to buy put options for a relatively cheaper price.

Cons of Hedging

Although hedging your portfolio can minimize the downside risk of your portfolio and provide greater realized returns, hedging comes with its downsides that cannot be ignored.

The list below discusses just three cons of hedging, which investors may overlook:

  • Complicated: Hedging an investment portfolio is not a simple strategy to maintain, and is certainly not meant for beginner investors. Ultimately, this is due to the investor requiring an understanding of the financial markets, the implications of different interest rates and inflation rates, and becoming comfortable with putting money into "new" assets and hoping that it all works out. Additionally, if you want to keep a consistent hedge, you'll need to continually adjust your positions, which can be very time consuming. Options and futures can also be relatively higher-risk, and can clearly add to your risk profile if not properly managed.
  • Costly: If you hedge your portfolio, you'll technically also be reducing your upside by paying some kind of price (i.e., an option premium) to minimize your downside risk if the market were to fall. Moreover, the more likely you are to benefit from using a hedge, the more costly it becomes to set up. Therefore, while you may avoid a big drop in the stock from something like a put option, you may not be in a better position if you paid a small fortune for the protection. So, while there's nothing wrong with investing in certain stocks to eliminate risk exposure, for example, trying to augment your entire portfolio to protect you from likely declines can be complicated, time consuming, and expensive, especially when using derivatives.
  • Return Potential: Hedging a portfolio can also limit return potential, as higher return equals higher risk. In other words, it can be difficult to achieve a high return while essentially bubble-wrapping your portfolio. Regardless, most investors can achieve great returns and necessary risk management by focusing on the long-term, employing proper asset allocation, diversifying their holdings, and being smart with what they invest in.

All things considered, explicitly hedging your portfolio is not a necessity to become a successful investor. However, if hedging is employed properly while managing one's risk profile, hedging can certainly lead to higher average returns over the long-term.

The Bottom Line

In summary, a portfolio hedge is just another investment that costs money to deploy and a proper strategy to see its realized benefits. Portfolio hedges should generally be utilized before there's a lot of panic and fear in the market, so that you're able to position correctly for it. By understanding all of the portfolio hedges discussed in this article (cash, fixed-quantity/defensive assets, the VIX, and options), you can identify which hedges to deploy to effectively hedge your stock portfolio.

The goal of hedging an equity portfolio isn't to make money, it's to protect from losses. Therefore, you must carefully consider the cost of hedging, as this cannot be avoided, as well as the potentially significant cost(s) if you're wrong about your hedging bet. Hedging a portfolio is also not an exact science, but the strategies discussed in this article are the most viable for the average investor. Even so, achieving the perfect hedge is extremely difficult to achieve in practice.

Fortunately, if you're hedging an equity portfolio that forms part of a diversified portfolio, your entire portfolio is already hedged to an extent. In this case, a smaller hedge would be required. Regardless, hedging one's portfolio can be a valuable strategy to protect against downside risk if appropriate risk management strategies are established.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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