U.S. equities have experienced solid gains over the first half of 2014 without experiencing any significant correction in prices.
Sure, there have been some mild pullbacks, including a 6% drop in the S&P 500 Index in January, but as earning season for the second quarter begins, investors should be aware of different ways they can hedge their portfolios if they believe that stocks might fall.
One of the most efficient ways to hedge a portfolio is to trade options. Options can be used like an insurance policy, as an investor pays a premium to protect against an adverse move.
Put options are one such strategy. Buying a put gives the owner the right — but not the obligation — to sell a stock or exchange-traded fund at a given price on or before a specific date. By purchasing a put, an investor is paying a premium to the option seller, and has the right to sell a stock if the price of the security moves lower.
For example, if an investor purchases a $190 put on the SPDR S&P 500 ETF (SPY) — an ETF that tracks the S&P 500 — expiring in December 2014, they will have the right to sell the ETF (and will likely do so) at $190 if the price falls below that mark.
The options are only active until the expiration date (in the example above December 2014). If the price of security is above the strike price on the expiration date, the option will expire worthless. However, the most you can lose in that scenario is the price paid for those options. In this case, the price on the option is $4.81.
Thus, the breakeven price on the trade would be the strike price ($190) minus the price on the option ($4.81), or $185.19.
Shorting Stocks or ETFs
Another way to hedge a portfolio of stocks is to short an ETF that represents an index.
When you short a stock or an ETF, you borrow that stock or ETF from a broker and sell it with hopes that it will decline in price so you can buy it back at that lower price, replace the share he borrowed and profit off the difference.
So if you short the SPY and the price moves lower, the profits made from the S&P 500 going lower should help offset some of the losses in the various stocks and funds already in your portfolio.
There are direct costs to shorting stock. You have to pay a broker for the right to borrow the stock, and you must have a margin account to short. The borrowing costs are different for each security, too; typically, the more illiquid the stock/ETF, the higher the borrowing rate. The nice thing here is that the SPY is highly liquid.
Still, for an example, if you want to short the SPY, your broker might charge you 2% annually to hold the short position. So if you borrow $10,000 worth of the SPY, your cost for borrowing over the year would be $200.
And the risks are significant, too. Should a stock in fact go up, you will not only lose out by however much the stock increases, but you’ll be out the borrowing costs too — and because stocks theoretically have unlimited upside, short sellers who don’t pay attention to their positions can suffer enormous losses.
One of the biggest such risks involves a so-called “short squeeze,” in which a piece of good information causes short sellers to try to cover their positions by buying all at once, causing the price of the stock to suddenly spike.
Buying Inverse ETFs
Perhaps the most accessible way to hedge the market, however, is just buying an inverse ETF — a fund that moves in the opposite direction of an underlying security.
A good option for these purposes is the ProShares Short S&P 500 (SH), which is designed to achieve returns that are inversely correlated to the SPY. Because the fund charges 0.9% in expenses, and uses various swaps and mechanisms to create the inverse effect, returns won’t be a direct inverse 1-for-1 — but it’s still an adequate proxy.
Do be warned, though: Similar to shorting, an inverse ETF can generate significant losses as the S&P 500 Index is not capped and has unlimited upside.
As of this writing, David Becker did not hold a position in any of the aforementioned securities.