• Pierre Fournier

Alternatives to Protect Your Portfolio if You Believe That the Market Increased Too Quickly

By: Prof. Pierre Fournier


With markets continuing to work higher and higher, I have been receiving several questions from students on how to protect their nice embedded gains in the stock market. Many investors are unfamiliar with hedging strategies, of which there are many. Let’s take a look at five ways you may be able to protect some of your recent stock market gains. Some of these methods have major drawbacks and they all, with the exception of one, carry some significant risks.


Cash

Investors are surprised when I tell them the best hedge is usually cash. I am confident in markets (and why not — they have risen for more than 100 years) and I typically suggest that investors hold on to enough cash to reach the ‘sleep at night’ level, where investors can sleep peacefully knowing that their reserved cash will provide them with the opportunity to take advantage of market downturns. I cannot predict the market and neither can you. ‘Going to cash’ is never a good idea, but holding some cash so you don’t panic in a bad market is never that bad of an idea, either. Cash doesn’t cost anything, it even earns a minuscule amount. More importantly, cash does not go down if your hedge does not work. If the market goes up, your cash is still there. Most, if not all, other hedges will lose money when the market goes against you. Most other hedge products carry borrow fees to short or management fees. Cash does not. Cash is also the most flexible and liquid security if you change your mind on the hedge and find an attractive investment opportunity.


Short selling indices

The easiest way to protect your portfolio from a decline in the overall market is to short the market using ETFs such as SPY for S&P 500 exposure, or QQQ for Nasdaq exposure. If you are not comfortable shorting, there is the option to buy an inverse ETF, such as SH, which will rise if the market declines. Most investors are scared of shorting because if one short sells a single company, then potential losses have no limit (think of someone shorting Apple years ago at $7). But shorting a market index is not nearly as risky. Sure, markets can move against you. But an index cannot be taken over at a premium, and owning dozens or hundreds of stocks in an index product dramatically reduces single-company risk. Shorting an index is simply an easy hedge against a market decline. The drawbacks are costs: it costs money to short and to cover dividends. The dividend on the S&P 500 is 1.5 percent right now. With shorting costs, the market likely needs to drop about five percent for this hedge to be successful. While inverse ETFs do not cost anything more on their own, they have high management fees. For example, SH’s fee is 0.89 percent. We may agree that single inverse ETFs are ‘OK’ for hedging, but I would advise all investors to avoid double- or triple-leveraged ETFs like the plague. These are toxic products.


Pair trading

In pair trades, rather than selling a stock you like, you short sell a company you like ‘less’ within the same sector or index. For example, supposing you own Facebook, you could short sell Snapchat shares as a hedge. You still take on the individual company risks in shorting, but in this case your two positions are in the same sector, so you do eliminate sector risk. In addition, while most investors find fundamental analysis difficult, they find it easy to say, “this company is better than that company” overall. Another point is that this avoids the tricky issue of valuation: even if the sector you are pairing is massively overvalued, it won’t matter as long as your ‘good’ company outperforms your ‘bad’ company.


Buying puts

Many investors will buy put options to protect positions. Certainly, these can work as a hedge, but this strategy can be very expensive. Suppose you have made a lot of money on Tesla (TSLA on Nasdaq). Many investors have actually done so as the stock is up about 700 percent in a year. As I write this, the stock is US$850. But a February US$850 put option, which expires in 28 days, will set you back US$71.00. This gives you the right, but not the obligation, to sell shares at US$850. An investor needs to pay 8.3 percent for one month of insurance on the stock. If Tesla shares are above US$850 on February 19, this option will be worth $0, and another put will need to be bought to maintain a hedge. Now, suppose one wants a longer term to hedge. The Tesla March 2022 US$850 puts will cost you US$272 per contract today. This is a 32 percent insurance premium based on the current price of the stock. Could shares fall that much? Sure they could. But if they don’t, you’ve just lost 32 per cent, and shares have to rise above $1,100 for you to now break even on the hedge.

Selling ‘in-the-money’ calls

Many investors do not know about this strategy, but it is one of the better ones. Suppose you own Netflix (NFLX on Nasdaq). It is near US$600. Maybe you have owned it for five years, at a cost of US$100. Rather than shorting the market, buying puts, or shorting a pair trade in, say, Disney, against the position, one could sell a June US$550 call option. Because you own the stock, this is a covered-call position. Currently, one can get US$78 for this option contract. If the stock is still above US$550 by June, you will have to sell it. But since you got US$78 for the contract, that’s the same as selling it at US$628 (US$550 plus US$78). In this hedge, the stock can decline by a decent amount and you would still make money. There is still risk: if the stock drops below US$550, you are still going to own it. There is also a potential tax hit if the stock is called away (however, one can buy the option back to prevent this). For this hedge you are basically selling time to another investor, as your own hedge.

Disclaimer: This article is intended to be used and must be used for informational purposes only. It is very important to do your own analysis before making and investment based on your own personal circumstances.

Sources : BNNBloomberg, Reuters, The Economist, Les Affaires, La Presse, CNBC.

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