Market Beat: Portfolio hedging
To hedge an investment portfolio means that you will take some defensive measures for portfolio protection. There are many tools available for hedging purposes.
The term “hedging” has been used regarding investments for hundreds of years. Its origin goes back to medieval days when property owners would plant a hedge around their homes to keep unwelcome visitors out. Apparently, hedges were just as effective as fences as they were widely used in the old days.
Hedging your portfolio involves using a risk management strategy. Ideally portfolios should be designed for risk management through proper asset allocation and diversification and investors should be prepared for the inevitable periods of high volatility and market downturns. Investors should also invest for the long haul and not get overly concerned with short term market fluctuations.
One disadvantage to hedging is that it comes with a cost. Kind of like buying insurance on your home. If the house burns down, you’ll be glad you had it, but you do have to pay for it whether you use it or not.
Put options are one way to hedge and of course options are not suitable for all investors. By purchasing a put option, it gives you the right but not the obligation to sell your underlying stock or exchange traded fund at a set price by a certain date. The price is known as the strike price and the date is the expiration date of the option contract.
Put options can be purchased on individual holdings or you can benchmark your portfolio to an index like the S&P 500. Calculate your portfolio’s beta to the index, then you can determine how many index options to buy to provide overall portfolio protection against a broad market decline.
Inverse exchange traded notes or ETNs can also be used effectively for hedging. They are designed to move in the opposite direction of the underlying index and can offset market declines. It’s very important to remember that inverse ETNs are not long-term investments and can erode in value over time because they are based on futures contracts, in market jargon, this is referred to as the “contango” effect.
If you’re going to use inverse funds, know the time frame that you want to use them for. You might decide to add some around a known calendar event like an election or a Fed meeting that could have market impact.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.