How To Hedge A $500k Tech Portfolio
One of the advantages of ETFs is that the most widely-held ones often have options traded on them. That enables an investor to hedge them. But an investor can also use an ETF as a proxy to hedge other investments against market risk. In this post, we'll walk through a step-by-step example of hedging a portfolio of tech stocks or funds using the PowerShares QQQ Trust (NASDAQ:QQQ), which tracks the tech-heavy Nasdaq-100 Index.
Step One: Choose A Proxy Exchange-Traded Fund
The first consideration is that the ETF will need to have options traded on it, but as we mentioned above, most of the most widely-held ones do. The second consideration is that the ETF be invested in same asset class as your portfolio. For this post, since we're dealing with a hypothetical investor with a $500,000 portfolio invested in technology, we've chosen QQQ.
Step 2: Pick A Number Of Shares
In order to hedge a $500k equity portfolio against market risk, you would want to hedge an equivalent dollar amount of your proxy ETF. Since QQQ traded at $67.93 on Thursday, you would simply divide your portfolio dollar amount, $500,000, by $67.93, and use the quotient (rounded to the nearest whole number), 7361.
Step 3: Pick a Threshold
Threshold, in this context, means the maximum decline in the value of your position that you are willing to risk, as the screen capture below from our hedging tool Portfolio Armor explains.
What is the maximum decline you are willing to risk? Generally, the larger the decline, the less expensive the hedge, and vice-versa. In some cases, a threshold that's too small can be so expensive to hedge that the cost of doing so is greater than the loss you are trying to hedge. I generally use 20% decline thresholds when hedging equities, an idea borrowed from a comment by fund manager John Hussman:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we'll enter 20 as our threshold, along with QQQ as our ticker symbol, and 7361 as our number of shares in our hedging tool, Portfolio Armor. Since we're entering a number of shares that includes an odd lot (i.e., less than 100 shares), and since each options contract covers 100 shares, Portfolio Armor will slightly over-hedge the 7300 shares, if necessary, so that the total value of the 7361 shares is protected against a greater-than-20% drop.
Step 4: Find the Optimal Puts
A few moments after tapping "Done", we'd be presented with the optimal puts* to hedge our proxy ETF. The screen capture below shows the optimal puts, as of Thursday's close to hedge against a greater-than-20% drop in QQQ.
As you can see at the bottom of the screen capture above, the cost of this protection was 0.85% of your position value.
How This Hedge Would Protect Your Portfolio
Remember, the reason we picked QQQ in this case is because our hypothetical investor's funds were invested in tech stocks or funds. If those tech investments drop in value due to a market decline, most likely, the Nasdaq 100 Index will have dropped as well. And if the Nasdaq 100 has dropped, the ETF tracking it, QQQ, will have dropped as well. If the Nasdaq 100 drops more than 20% -- if it drops 20.5%, 30%, 40%, or even more -- the put options above will rise in price by at least enough so that the total value of a $500k position in QQQ + the puts will have only dropped by 20%, in a worst-case scenario. The puts may, in some cases, provide more protection than that. For an example, see this recent post about hedging Affymax, Inc. (OTCPK:AFFY).
Put options move in a nonlinear fashion, which enables a small dollar amount of them to hedge a much larger dollar value position in an underlying security.
Hedging A Portfolio Of Stock And Bonds
The example above is simplified in that we've assumed our hypothetical investor's portfolio is entirely invested in technology stocks or funds. But what if he had some bond investments too? In that case, we could use a similar process to hedge his portfolio against market risk, except instead of using just one proxy ETF, we'd use one per each asset class. So, for example, if 60% of the investor's assets were in tech stocks, and 40% in investment grade corporate bonds, we might scan for optimal puts for a $300k position in QQQ and then scan for optimal puts for a $200k position in the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD).
*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones. The screen captures above are from the Portfolio Armor iOS app.