If the possibility of a market downturn has you worried, and you are reluctant to liquidate your holdings, you might want to consider purchasing some insurance for your portfolio. Here I am referring to a process called ‘hedging’, which ensures that your downside risk is limited by purchasing a financial instrument that will offset any loss incurred in your portfolio.
As with insurance, there are of course costs involved, and these will reduce any profit you may otherwise experience, but to many this is an acceptable compromise. When you hedge you pay a price, but what you get is security and peace of mind. Nonetheless there are a number of considerations that you should be aware of.
There are a variety of instruments that will allow you to hedge, and while each will have their own unique characteristics, not all may be suitable for your goals. Hedging is most often performed by using derivative instruments such as options, futures or CFD’s. One problem with futures and CFD’s is that the process of hedging not only acts to nullify your losses, but also your gains. When you hedge with options however, only your downside is limited; you are still able to benefit from the growth in your portfolio.
One must however be careful to avoid assuming that this means there is no associated risk. The premium you pay for the put contract will act to lower any gains you may make on the underlying shares. In order to be profitable, your shares must make enough of a gain to off-set the cost of the premium. For example, let’s say that you purchase shares at $10 each and at the same time buy a put contract with a $1 premium that allows you to sell you shares at $10. While you are guaranteed to be able to sell your shares at $10 no matter what happens on the market, your shares need to rise to $11 just to break even, and that’s before brokerage costs are considered.
On the other hand, you do not start to profit from your options position until the underlying stock price drops below $9, because again the cost of the contract must be considered. So in essence, if the share price fails to drop below this level, the hedging process will have resulted in an overall disadvantage.
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Another problem with using put contracts is that each contract covers 1000 shares. This means that in order to achieve a perfectly hedged position, you must hold 1000 of the underlying shares. For companies with high share prices you therefore need a large holding. For example, with Cochlear shares currently trading around $50, you need $50,000 worth of shares in order to achieve a 1:1 hedge with a single options contract. It also means that it can take a lot of different contracts to hedge a large portfolio. If you have 15 stocks in your portfolio, you need to buy at least 15 separate options contracts (and incur 15 separate brokerage charges) to hedge your entire portfolio.
So you can see that hedging with put options can be a very costly exercise, and will fail to offer you any protection against modest falls in the market. In fact, the options hedging process is usually only ever worthwhile when you expect reasonably rapid and significant losses. Furthermore, you will also no doubt see the difficulties in continually hedging a portfolio: because markets go up more often than they go down, a policy of constant hedging over the long term will only act to weaken your profits.
So what can you do to protect your portfolio without incurring crippling costs? The use of index options may provide a more practical solution. Because index options obviously track an index, such as the S&P ASX 200, they will only provide a hedge against a portfolio that broadly follows that index. Nonetheless, this will tend to be the case for any well diversified portfolio of larger cap stocks.
In order to work out how many contracts you will require to hedge your portfolio, you simply work out what each options contract is worth by multiplying the index value by the point value. For example, if you buy a put contract on the ASX 200 with a strike price of 3700 points and each point is worth $10, one contract will cover $37,000 worth of shares. You simply divide your total portfolio value by this amount. For example if you have a portfolio worth $100,000, roughly 3 contracts will provide you with a reasonably effective hedge. Again, this strategy does not offer you the prospect of perfectly hedging your positions, but you will find that it will provide a substantial buffer against falls in the broader market.
For example, let’s say you have a diversified portfolio of stocks worth $100,000. The ASX 200 is currently trading at 3,700 and you are worried that the market could experience another leg down and want to purchase some insurance. On the options market you purchase 3 put options with an exercise price of 3,700 expiring in 2 months at a price of 200 points each, or $2,000 each. That’s $6,000 altogether for the 3 contracts.
Now, let’s say that the market and your portfolio experience a 20% fall over the following 2 months. With the ASX 200 index now at 2,960, you exercise your options and receive $7,400 for each contract ($10 for each point difference between the exercise price and the index level at expiry), or $22,200 for the lot. If we factor in the initial cost of the options, that leaves us with $16,200 in profit. Although your portfolio has dropped $20,000, you have managed to largely off-set this with your options position.
Of course we must remember that if the index remains above 3,500 we will fail to benefit from the hedge (again, we have to account for the cost of the options). Furthermore, any profit we make from a rising market will be lowered by the cost of the options position. Don’t forget that the hedge position cost us $6,000 to set up, and that only offered 2 months worth of protection.
As is always the case, we will only ever know if hedging will be worthwhile with the benefit of hindsight. But that’s not the point. The point of hedging is that we ensure we are protected against sudden, significant and unexpected losses on the market. As is so often the case with investing, we need to accept that a compromise needs to be made. We can avoid the costs of insuring our portfolio and accept the possibility of suffering an unexpected loss. Or, we can accept the cost of hedging but sleep safe at night knowing that our capital is protected.
As mentioned, a continuous hedging policy is likely to be a costly and largely unnecessary endeavour, so you are best adopting such a strategy only at certain times. Specifically, if you are looking to access your capital in the near term and don’t want any nasty surprises in the interim, hedging can be well worth the cost. Additionally, if you are particularly concerned about the potential for the market to drop and don’t want to liquidate your holdings, a simple hedge with index options is a very viable alternative.
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