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Hedging 101

By Mark Bern, CFA


There are several ways to hedge against a major correction in stocks.  I will provide a little explanation here on the four strategies that I sometimes use, depending on where the market is in its cycle.  For more elaboration you may need to read some of my older articles on Seeking Alpha.
Using Put Options
My favorite method of hedging is to buy put options on stocks that tend to perform the worst during recessions.  I have written extensively, including a series on the subject that is still in progress.  But I only use this method when I believe we are nearing a top in the markets based upon several factors such as weak internals, inverting of the yield curve, or a lack of momentum in the markets with extremely high valuations (to name a few). 
I try to identify companies in industries that tend to fall more precipitously that the market in general during recessions, such as travel related, industrial or consumer discretionary businesses.  I sift through those companies to identify the ones that have fallen the most during the last two recessions.  Generally, when the market went down by 50% these companies fell by 66% or more (some by more than 90%) from cycle highs. 
Next I eliminate those that have improved fundamentals since before the last recession, such as reduced debt levels or increased margins.  What is left are those that I consider candidates to buy puts options on in, and only if, the potential for profit from a trade meets my personal requirements.  I generally do not enter into a position unless I believe it has the potential to return at least 1,000% in a bear market pull back of 30% or more.  I also like maturities of six to nine months to give the market enough time to fall far enough that much, if not all, of the potential is attainable.
I use out-of-the-money put options to keep the cost low and do not exceed using 2% of my portfolio in any given year to implement this strategy.  The key is that it only takes one or two of the companies to have a really bad earnings report for me to recoup the total cost of my hedges for the year.  When/if that happens (and it has happened often for me) my hedging cost fall to zero, or at least close to it.
I had been hedging using this strategy from 2014 and well into 2016.  But when I saw the possibility of an upset in the elections late in 2016 I considered the possibility that the economy could actually improve and so I stopped hedging.  I am glad that I made that decision, perhaps prematurely, but it has worked out well so far.  I will deploy hedges again once I begin to see the signs of a potential economic slowdown on the horizon.
This strategy works best (costs the least) when the market participants are still optimistic about the next few months because the premiums I pay for the puts are less.  When the market begins to fall the premiums rise making the strategy more expensive. 
Of course, there are other ways to use put options in a hedging strategy but I do not recommend them personally because the cost is usually much higher.  And, of course, we don’t know whether the hedge will be necessary or if it will expire worthless, so the less money we commit to it usually the more efficient it can be.
Using Inverse ETFs (Exchange Traded Funds)
I want to start this section by reminding people that a leveraged inverse ETF will always (ALWAYS) decay in value (price) unless the market falls for an extended period.  If the market falls then rises and then repeats, creating a range-bound market, the leveraged inverse ETF will decay.  Look at the long-term charts for any of them and it will become obvious.  Every few years these instruments require a reverse split to bring the price back up to a reasonable level.  So, buying and holding a leveraged inverse ETF is a bad option unless the market is in a sustained free fall.  Even then it is best to not stay in a leveraged inverse ETF for very long.  The market often rallies during bear markets and all your gains could evaporate in just a few days. 
Second, I should also mention that inverse ETFs, whether leveraged or not, use derivative instruments (futures, options, or other highly leveraged and time-sensitive securities) with expiration dates.  This means that the entire ETF, or at least a large portion of its holdings expire and must be replaced every month or two.  This often results in exaggerated volatility that does not necessarily match the actual market activity that the ETF is designed to mimic, especially around the expiration/replacement dates.  And, of course the leveraged ETF volatility can be even more exaggerated than the unlevered ones.
However, the good aspect of these securities is that they can be very effective when used during a market crash or correction.  It is hard to detect when the “real thing” is happening until it gets up a head of steam but once we can see that a sustained drop is in progress inverse ETFs can be very useful in protected at least a portion of our hard earned gains.
Using Long/Short Stock Positions
The history of long/short portfolios is absolutely horrible.  The reason is because too often portfolio managers invest based more upon the story rather than the real fundamentals.  And even when the fundamentals are used as the basis for selecting the candidates, technical analysis is often overlooked meaning that a stock with terrible fundamentals may have a rabid following that creates momentum which often overrides the fundamental outlook for a stock. 
There are, of course, other reasons why the strategy fails more often than not but I will try to emphasize a more practical approach that emphasizes superior analysis on both sides of the equation.  The key is selecting stocks that have great potential upside to buy and pairing those positions with stocks of companies that are on the verge of collapse (or rapidly moving in that direction) to sell short.
Too often investors try to match the best and worst stocks in a single industry.  But time and again a rising tide can lift all boats so when an industry is doing well even the worst stocks can perform better than expected.  Even if the long position outperforms the short side the limited allocation to the longs creates a drag on overall portfolio performance.  The better way to match pairs is to widen the pairings to sectors as an entire sector can have both winners and losers more readily. 
I use the Friedrich algorithm to help me select my long positions, of course, and I also use it as a screening tool to begin the process of finding my shorts as well.  A good short candidate must have several qualities: it must lack momentum (and not be a darling of Wall Street); it must carry an excessive amount of debt, usually resulting from overpaying for an acquisition(s) that did not work out as planned; it must generate negative free cash flow; it must have a weak cash position (I like a quick ratio below 0.8).  Put all that together and you have a company that is heavily indebted, short on cash, unable to generate enough cash to sustain operations with no tangible assets available to use as collateral to raise additional funds.  But I need all of those at the same time so patience is key and using the right tools to sift through the thousands of stocks are a must.
Using Bonds to Hedge a Stock Portfolio
First, I don’t invest much of my portfolio in bonds when interest rates are low and especially not when rates are rising.  Remember that the price of bonds and their respective yield have an inverse relationship.  When the yield rises the price falls and vice versa.  So, when interest rates (yield) is rising the price of a bond (principal) will fall.  The degree to which the price moves relative to yield depends upon the time to maturity of the bond. 
As an example, a U.S. Treasury bond with nine years to maturity will fluctuate in price approximately 8% for each 1% rise or fall in yield.  So, if you hold a ten-year bond today yielding about 2.93% (currently) and the yield rises to 3.9% one year from now the value will fall by about 8% (it becomes a 9-year bond after a year).  The Fed intends to raise interest rates by about 1% over the next 12 months so an 8% loss is almost certain if you buy a 10-year bond today. 
Of course, the idea behind buying bonds as a hedge is to hold until maturity thereby incurring no risk to the principal.  The problem is that you are also locked into a lower yield than you could otherwise have achieved if you had waited another year (or longer).
My preference is to not add new bonds positions until the Fed appears ready to at least hold rates steady after a series of increases or until it makes its first move to reduce rates.  It always seems better to me to hold bonds when interest rates are falling because the price of my bonds rises to offset losses to stocks during a recession.  When does the Fed begin to reduce rates?  When the economy slows and Fed officials are trying to provide support to an economy likely to fall into recession (if it has not already done so).  So, in a recession we lose money on our stock positions but we make money on our bonds positions to reduce the pain. 
That is the reason that a good, conservative portfolio manage will increase his/her allocation to bonds early in a recession and then increase allocation to stocks when the economy begins to recover.  This is also why those same savvy managers increase the duration on bonds when rate increases stall and why they will shorten the duration when rates get really low.
If your advisor does not actively manage your portfolio, using at least a partial hedge strategy when stocks begin to fall your portfolio may underperform.


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