Hedging is the purchasing of securities designed to reduce portfolio risk. These securities are intended to increase in value, offsetting the losses of other positions. I feel it is a necessary part of any diversified portfolio to have some type of active hedging strategy. Even though this could limit potential returns, it could also save your precious hard earned money by limiting cataclysmic losses. Think of it like health insurance for your investments.
As discussed in my recent article, there are several controversial reasons why the market could meet resistance fairly soon. One of them is that Apple (AAPL) has arguably carried many stocks and indexes higher. Some examples of this are Telecoms: AT&T (T), Sprint (S), Verizon (VZ), APPL Suppliers: Qualcomm (QCOM), Skyworks (SWKS), Cirrus Logic (CRUS), and select Indexes/Funds: QQQ (QQQ), SPY (SPY) and FCNTX. In addition, there are some concerning technical signals. Read about them here.
Since I am mostly a long investor via stock and call options, I use put options and short stock positions to hedge against a possible market downturn. The least risky and usually more favorable is put options, mostly because the maximum loss is the premium paid for the contract. Conversely, shorting stock leaves you vulnerable to unlimited losses. Lets explore a put position that may offer a long portfolio some beneficial hedging against a moderate pullback.
SPY Put Spread:
Buy the Nov '12 140 strike for 4.32.
Sell the Nov '12 130 strike for 1.68.
|Net Max Cost||$264||1)4.32-1.68=2.64|
|Net Max Gain:||$736||1) 140-130-2.64=7.36|
|Pullback needed for profits to begin:||2.58%||1) 141-(140-4.32+1.68)=3.64 2) 3.64/141=2.58%|
Figures as of market close 8/31, SPY= 141/share
Even though the maximum profit would require a seemingly large 9% pullback, it is not out of the question. Just 2 months ago, the May decline brought us to this level. On the flip-side, the 2.58% pullback required for a net-gain is a fairly reasonable expectation, considering the expiration for this trade is November 16th; about 2 1/2 months out.
Initiating this "Long Put Spread" will help alleviate a moderate, near-term pullback in the S&P 500, for a low net cost of 264$. A simple spread such as this one, on a major index, could be a great start to hedging against a pullback in a net-long portfolio. I am not implying a pullback is looming; I am only suggesting hedging against one is intelligent for most portfolios.
Disclosure: I am long AAPL. I may initiate a long SPY put spread over the next 72 hours.