Sell Or Hedge?

by: Martin Vlcek


Many traditional hedges are not working as well as they used to.

Crowded trades in some hedges increase the risk of them reversing.

Hedging is exacerbating the stock and commodities rout.

Until there are more attractive hedges and/or until investors view stocks as so attractively valued that they don’t need any hedge, the sell-off is likely to continue.

Some high-quality stocks offer a unique opportunity to buy them at high FCF and dividend yields.

sell This is a follow-up on my article about the real reasons behind the recent sell-off, and I would like to thank everyone for the excellent comments. Large investors who are now caught holding substantial positions in Chinese stocks are unable to sell most of them due to the restrictions. Their natural reaction is to sell some other correlated assets as a hedge of their ongoing China exposure. Until they hedge as much of their Chinese stocks' exposure as they need, the sell-off around the world and across asset classes will continue.

In the past, when you wanted to hedge long stock market exposure, you could simply de-risk by moving to U.S. Treasuries (NYSEARCA:TLT) without losing much profit potential while greatly lowering the volatility of the portfolio and the downside risk. Other hedges include the U.S. dollar (NYSEARCA:UUP) long or shorting other currencies such as the Japanese yen (NYSEARCA:FXY) and the euro (NYSEARCA:FXE). Yet, more hedges are provided by being short commodities, including oil (NYSEARCA:USO), long gold (NYSEARCA:GLD); long VIX futures or their proxies (NYSEARCA:SVXY); long stock index put options or short index futures and short individual stocks. Selling covered calls and collecting dividends can also be considered as a partial hedge.

While today, all of these hedges are still theoretically available, many of them trade at unattractive valuations (low yielding where applicable or having a negative carry or negative contango/backwardation) and most of these trades are very overextended. Some are also less useful than before for other reasons mentioned below, such as central bank interventions. Let's go through the hedges one by one:

The U.S. Treasuries

After a 30-year bull market in Treasuries culminating in a ZIRP policy for seven years, yields are extremely depressed by historical standards in the U.S. and even more in other developed countries that are considered to be relative safe havens. By diversifying into Treasuries, in the long run, portfolios lose lots of potential future returns compared to the past. Not only is the yield portion low, but also the capital appreciation potential is limited as well. The risk-reward is not compelling (little upside versus lots of downside if interest rates normalize), and the poor upside vs. downside means that you need a larger Treasuries position to hedge the same amount of risk than before, making it less capital efficient. Hence, a move to Treasuries can increase the overall portfolio leverage and risk.

Moreover, there is a higher risk that the "good" inverse correlation of Treasuries with stocks that investors are seeking when hedging could become just neutral or could even reverse. If Treasuries started selling off into the stock weakness, then we would see a true mayhem. The triggers may be sovereign wealth funds and foreign central banks selling, the Fed reducing its balance sheet or a total flight to cash.

One-year chart of the S&P 500, long-term U.S. Treasuries and gold:

SPY Chart

SPY data by YCharts

The U.S. Dollar

The long U.S. dollar trade has been working great in the past two years. But by some standards, the U.S. currency is already overextended. Even at the current levels, the currency is choking U.S. growth, hurting companies with foreign exposure. The negative deflationary effect on non-U.S. economies is even stronger (via U.S.-denominated debt problems, weaker volume demand or lower volumes consumed due to higher real local currency prices, weaker commodity prices, etc.). The long U.S. dollar could easily be peaking and could even reverse abruptly on any large short covering (of non-U.S. short currency positions). However, any euro or yen rally is likely to be muted due to the reasons described right below (ECB, BOJ). While the U.S. dollar hedge covered the losses in the S&P 500 for the past 12 months (dollar up over 4% while the S&P was down roughly as much if dividends are included) and the short euro trade gained 6%, the short yen trade is roughly flat.

One-year chart of the S&P 500, U.S. dollar, euro and yen:

UUP Chart

UUP data by YCharts

The Yen (And The Euro)

With central banks around the globe doing "whatever it takes" in effect to devalue their respective currencies, the yen and euro rallies have been very muted in the stock pullbacks. Investors going long them are essentially betting against the unlimited selling power of their respective central banks. These interventions have caused that euro and yen are of no real value now as safe havens. Shorting the yen or euro brings with it the benefit of the positive carry trade where the relative interest rates on the shorted currencies are lower than on the long currencies (U.S. dollar).


Short commodities remains one of the few hedge trades that is still working very well. This partly explains its outsized fall vs. other asset classes (of course, weaker demand and oversupply played a role as well). Short commodities serves as a solid U.S. dollar proxy. In addition, it also hedges the global growth downside risk. As if these benefits were not enough, many commodities are also in severe contango, notably oil and gas. So, oil and gas serve as an excellent "triple-play" hedge.

One-year chart of the U.S. Commodities Index (NYSEARCA:DBC), S&P Energy (NYSEARCA:XLE), United States Oil Fund , Unites States Natural Gas Fund (NYSEARCA:UNG)

DBC Chart

DBC data by YCharts

The high contango has also protected the weak producers by providing outsized financial profits from selling oil and gas futures hedges. This is part of the reason why the oil and gas market oversupply is not clearing as quickly as many expected. Under strong contango, this situation can last literally for years as the financial gains raise the effective break-even price for many producers. If the market wants to clear quickly, the high contango forces the spot price and the whole curve to fall much lower in order to achieve the same effect of the lower price on the markets.

The demand for hedges from oil and gas producers as well as other market participants will probably continue driving the price of commodities low until the need to hedge disappears, either through the ceased production of oil and gas by producers or through lower stock prices and weaker dollar that investors will not require the hedge any more. Until then, this self-reinforcing cycle of hedging, which lowers the price of commodities, drives the stock markets lower, and creates more need to hedge, will continue.


Gold has been in a downtrend for several years, so most investors have lost their beliefs in gold's hedging power. Indeed, gold rallies have been very weak despite the sharp stock market pullbacks. Gold is not only a "currency," but also a commodity and the total meltdown insurance. Due to the strong dollar, commodities oversupply, deflationary pressures and the lesson learnt that massive QEs and ZIRPs don't create real world inflation (unless the money is actually put to non-financial, real-economy use), gold has lost virtually all its protection power, barring a tiny amount as an insurance against the total collapse of the currency system. So, in terms of large-scale hedging needs, gold remains very unattractive.

VIX Futures

This is still a decent hedge I believe. However, it is an expensive one due to the fact that most of the time VIX futures' curve is in contango, working against the long VIX holders. Time is working against them most of the time. But VIX futures are in the rare backwardation now, which increases their charm.

With the markets supported by many central banks, and with frequent sharp, sudden, short-term pullbacks in VIX mostly at the beginning and end of the trading day (central bank interventions to stabilize the markets), long VIX investors are essentially betting against the central banks being able to manage the pullbacks in an orderly fashion, which is no doubt an important goal of the central banks.

These frequent sharp pullbacks in VIX are also driving the volatility of volatility itself up (VVIX), making any options positions in VIX even more expensive. The zig-zag volatility moves are also increasing the volatility drag, which causes the inverse volatility futures ETFs such as XIV and SVXY to underperform their straight volatility counterparts such as VXX, UVXY, making them ineffective in this high volatility of volatility (VVIX) environment.

One-year chart of volatility futures fund (NYSEARCA:VXX) and inverse volatility futures fund (NASDAQ:XIV):

XIV Chart

XIV data by YCharts

Speaking of volatility, one viable strategy to partially hedge is to sell out of money (or at-the-money covered calls). While this provides some downside and can even keep some stock appreciation potential if sold out of money, there is still a huge downside risk if the markets crash. The collected time premium will be only a small consolation price compared to massive losses on the underlying stocks. Dividend stocks serve a similar purpose, but again, and together with covered call premium can provide valuable "dry powder" to keep purchasing at lower prices.

Stock Index Puts

This hedge is still available. Arguably, put options are not as expensive as they should be, given the sharp moves in volatility. However, the puts still cost a lot of money in relative terms because the future expected returns from stocks are now lower due to higher valuations. So the cost of protection may not be worth it in many cases as the net total return on stocks would fall below that of safer assets such as Treasuries. This means that in some cases, the best risk/reward trade is to simply reduce long stock exposure rather than try to hedge it. This low risk/reward conclusion is valid for many more hedges than before, and this is why the market sell-off continues. It is simply easier to "cancel" the long stock exposure (sell stocks) than try to hedge it effectively.

Shorting Other Stocks

One hedge not mentioned is to sell stocks not owned (long-short stock strategy). This is a viable alternative which seems to be working. However, this strategy is dangerous in highly volatile markets as it either forces investors to decrease the absolute long exposure, or forces one to be leveraged. This can backfire as short positions may increase at the same time as long positions fall. This usually happens during market stress, at the worst moment, when investors liquidate the positions in the prevailing direction of their holdings (selling stocks that they are long, buying to close those they are shorting).

Shorting The Indexes

Shorting the entire index has not been effective due to several large caps holding the entire S&P 500 (NYSEARCA:SPY) up relative to the rest of the market, causing the short index hedge to underperform the rest of the portfolio. So investors are forced to short individual stocks, and they try to choose the weaker performers, exacerbating the falls in these stocks, creating the circle of self-reinforcing selling as other investors need to hedge or close as these stocks keep falling.


In short (pun intended?), hedges are much less effective than they used to be, and there are far fewer viable alternatives now. Trades in them are concentrated and crowded, setting up a risk of a sharp reversal. Some hedges are still likely to work well, such as shorting weak individual stocks (exacerbating the stock selling), shorting commodities in contango such as oil and gas. Even selling covered calls and collecting dividends provides some downside cushion. But some of the hedging trades are overextended from the long-term fundamental point of view, others are too much at the mercy of the government and central bank interventions (yen, euro, Treasuries, even oil due to OPEC decisions and geopolitical risk).

Hence, from the long-term risk/reward point, it is often more advantageous to simply decrease the long stock exposure (exacerbating the stock selling) than to try to use an overvalued, overcrowded hedge that may not work as well as intended or may even backfire. Until stocks become cheap enough to warrant an unhedged long exposure, the selling is unlikely to stop. But there may be short-term counter-trend rallies of course, as well as reversals in the overextended hedges.

Are the stocks cheap enough to stand alone unhedged? You tell me. I personally see several solid names trading at attractive FCF and dividend yields, such as IBM (NYSE:IBM), Apple (NASDAQ:AAPL) and Gilead (NASDAQ:GILD), although the cyclical risk remains. I believe the "safer" segment (non-cyclicals more than the cyclicals) of the market should see some stabilization soon. On the other hand, however, stocks with relatively high debt and less predictable or even negative FCF will probably continue to be sold.

I am sure I've not covered all the hedges. I am eager to hear your comments. What hedges helped you protect your long portfolio in the current downturn? What has not worked or disappointed you? Or are you just long and reinvest the dividends? In any case, good luck to you all during these turbulent times and happy hunting!

Disclosure: I am/we are short UVXY, USO, UNG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.