Should I Hedge My Portfolio Against a Drop in Stocks? : November 21, 2019
Wouldn’t it be great if you could make money when the stock market goes up, but be protected from losses when the market goes down? Well, there are strategies designed to do just that, known broadly as hedging.
Hedging can sound like a no-brainer to investors, especially when reading literature from companies that specialize in these strategies. After all, who wouldn’t want to preserve upside returns while being protected on the downside?
The problem is that hedging is often not fully understood by investors, and can lead to disappointing results. Not only does hedging have significant costs that drag heavily on performance, it could actually make things worse by increasing rather than decreasing losses in your portfolio.
While hedging can be a useful tool for certain objectives, we believe there are more effective ways to reduce risk for most long-term investors.
What is hedging?
The definition of hedge is “to protect oneself from losing or failing by a counterbalancing action,” and you see hedging in everyday life. For example, when you buy car insurance, you are hedging yourself against the risk of accidents, theft, vandalism, and other unforeseen events.
In investing, however, hedging is more complicated than simply paying an insurance company annually. Hedging against investment risk means strategically using instruments in the market to offset the risk of adverse price movements. In other words, investors hedge one investment by making another investment.
There are many instruments that can be used to hedge against investment risk, such as options and futures contracts. For our purposes here, we’ll focus on a basic strategy: buying protective put options.
Example: Put Options
A put option is a security that can be purchased in the open market, and is basically an agreement between two investors: the option buyer who seeks protection, and the option seller who underwrites protection. The put option buyer purchases the right to sell, or “put,” a security to the seller at a specified price. For that right, the buyer pays a premium to the seller. Every put option has an expiration date ranging from months to years.
Let’s see how this works with an example. Assume you own Microsoft stock which trades at $100 per share, and you want to protect yourself against a 5% loss over the next month. You could purchase a 95 put option on Microsoft, and that put option might cost you $1 of premium. If Microsoft falls below $95 per share over the next month, you could exercise that put option, and the underwriter will be obligated to buy your Microsoft shares for $95.
With this strategy, you’ve preserved virtually all your upside while having limited downside. Say Microsoft rose to $120 over the next month, your gains on paper would be 19% ($20 gain less $1 premium). Meanwhile, if the stock were to fall the next month, the maximum you’d lose is 6% ($5 max loss + $1 premium). Pretty good, right?
After your one-month option expires, you could renew your protection by buying another one-month put option that’s 5% out of the money*. You could continue this process month after month going forward, a classic hedging strategy some investors use in practice.
You Can Lose More Than You Expect
Here’s the catch. Put options protect you wonderfully in those times when the market falls well below your contract price. They do less well at protecting you when drawdowns don’t coincide with the option expiration cycle, as pointed by Roni Isrealov in an article entitled “Pathetic Protection: The Elusive Benefits of Protective Puts.” Let’s look at how you can lose more than you might expect due to unfortunate timing of options.
Let’s assume in our Microsoft example you purchase the same 95 put option at a $1 premium, and Microsoft stock falls from $100 to $95 on the option expiration date. It wouldn’t make sense to exercise the option when Microsoft is trading at (or above) the contract price, so your option expires. You’re now down $6 ($5 loss + $1 premium).
You then re-hedge by buying a 90 put option for $1, again protecting yourself from a 5% decline, and Microsoft falls to $90 over the next month. Your put option again expires unexercised. So, even though you were protected against a 5% loss in Microsoft stock at points in time, you’re down 12% in 2 months. This kind of unfortunate pattern can continue for several months in a row.
In other words, if you’re protecting yourself with one-month put options over a multi-month drawdown, not only might the protection be weak, it could even increase your losses depending on the timing of the options and the premiums you pay. Which brings us to another problem with hedging strategies: the high cost of protection that adds up over time.
Hedging Can Be a Drag
The seller of a put option receives a premium as compensation for providing protection. To say it simply, option premiums tend to be more expensively priced than you would think based on the probability of bad outcomes.
Think of it this way. If options were fairly priced to purely reflect the probabilities of expected payouts, over time a hedged strategy should return about the same as an unhedged strategy, less a small profit for option sellers. Instead, a hedging strategy like the one described above can drag on performance by 4% and as much as 8% annually, and that’s before fees and transaction costs. That can wipe out an entire year of stock gains.
The reason hedging can be so expensive has to do with the fundamental nature of both buyers and sellers. Sellers of options need to be incentivized to underwrite protection, and tend to elevate premiums as they seek to maximize profits. Buyers of put options tend to overestimate the likelihood of a big market decline, thus also elevating the cost of protection.
Useful Tool for Some, Not for Others
So you might wonder why an investor would still choose to hedge given these drawbacks. Hedging can be a useful tool for certain investors and specific objectives.
Take someone who has a large restricted holding in their employer’s stock that represents 90% of their net worth, and they wish to sell the stock once the restricted period ends. It might make sense for such an investor to hedge the position with a protective put option until their stock is no longer restricted, thereby insuring a large and undiversifiable risk.
Hedging is not as useful tool for others. Take investors who believe that they can foresee market downturns, and try to hedge when the feel like the market looks shaky or bad news is on the horizon. Timing the market is challenging as empirical research shows. I’ve still not met an investor who can predict future market moves with any consistency, and this kind of approach is more likely to hurt rather than help performance in the long term.
There are other investors who say that hedging helps them stay invested during bad times, and that if they didn’t hedge they would miss out on market gains. While the psychological benefits of hedging are understandable, if buying an option to protect our investment eliminates the return on that investment, what’s the point? There are other ways to reduce risk for these investors to consider.
Alternatives to Hedging
There is no getting around the fact that risk and reward are closely related, and enduring periods of volatility is the price investors must pay to enjoy higher expected returns from stocks. If the downside risk of stocks is too much to bear, the first thing investors should consider is simply reducing their exposure to stocks.
Even a simple strategy of shifting a portion of one’s allocation to cash can be more effective than hedging. In his research, Roni Isrealov finds that a strategy that invested 40% in stocks and 60% in cash delivered similar returns as a hedged strategy with 5% out-of-the-money puts options, but with less than half the volatility and better protection during stock market downturns.
Investors could also reallocate part of their portfolio to complementary assets with higher expected returns than cash. For example, bonds and other fixed income securities tend to be excellent diversifiers of stock market risk, because they tend to be uncorrelated with stocks, and very often bonds can offset adverse price movements in stocks.
Investors who limit their exposure to the U.S. could consider broadening their exposure to other countries, something I’ve written about in the past. Investing globally does not guarantee protection, but on balance, it helps. As this video illustrates, a global stock portfolio has tended to bounce around less than a portfolio invested in the U.S. alone.
These alternatives all relate to the idea of diversification, which Nobel laureate Harry Markowitz described as “the only free lunch in investing,” or the only way to reduce risk without necessarily sacrificing returns over the long term. While diversification won’t completely eliminate bumps along the road, it makes the ride smoother, and in our experience leads to better outcomes for long-term investors.
Hedging is not a particularly useful way to invest. Not only do strategies offer less protection than people expect, they do so at a high cost. Hedging strategies may look attractive because they cater to a very normal human instinct; people want to participate in the upside, but they don’t want to participate in the downside, and there is no end to the creativity people have in finding ways of trying to make that happen. A better approach for long-term investors is to diversify away the risks for which they’re not compensated, and only take on the risk that they’re comfortable taking.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Options are not suitable for all investors. Typically, commissions are charged for options transactions. Please contact your financial advisor for a copy of the Options Disclosure Document (ODD) or for more information specific to your situation.
*An out-of-money option has no intrinsic value, which represents the value of exercising the option on that day.
Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.
The main risks of international investing are currency fluctuations, differences in accounting methods; foreign taxation; economic, political or financial instability; lack of timely or reliable information; or unfavorable political or legal developments.
Supporting documentation for any claims will be provided upon request.