The Upsides And Downsides Of 4 Popular Hedging Strategies

Dec. 15, 2017 7:23 AM ETBRK.A, BRK.B1 Comment
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By Eric Fry

Recently, many subscribers have sent me emails that express concerns about the U.S. stock market's lofty valuations. These subscribers want to know how to prepare for the "inevitable correction" and whether I would recommend any specific hedging techniques.

Unfortunately, there is never really a great answer to questions like these.

The U.S. market is certainly an expensive one. So buying stocks at their current lofty valuations is unlikely to be as rewarding during the next 10 years as it has been during the last 10 years. But trying to take proactive steps to guard against losses during a stock correction is never easy.

So what does an investor do?

The answer to that question is an intensely personal one. For example, an investor who has a large tolerance for risk and/or who is operating with a very long-term perspective may be comfortable holding a large percentage of their net worth in stocks.

Conversely, an investor with a low tolerance for risk and/or a short-term perspective may want to hold a relatively small percentage of their net worth in stocks.

In other words, a disciplined, personalized investment program is usually the best way to "hedge" your risks. If you remain within your comfort zone, you are more likely to give your investments the room they need to deliver large gains.

That said, almost every investor feels the urge to hedge against losses from time to time. So let's take a look at four of the most common hedging tactics...

1) Raise cash by selling a portion of your stock holdings. For most investors, raising cash by reducing exposure to stocks is the only hedging technique that achieves any degree of success. The biggest risk it imposes is the risk of losing out on future gains.

But even this simple tactic is fraught with drawbacks. First, selling stock triggers a capital gains tax obligation in taxable accounts. That means you pay a tax of 15% to 20% on your profits for the privilege of avoiding potential losses.

The second drawback of selling stocks to avoid losses is that you never really know when you should repurchase the stocks you sold. It is easy to make the mistake of selling out of a winning stock and then never buying it back before it resumes moving much higher.

2) Buy protective put options. Put options provide another form of hedging. Typically, an investor would buy put options on an index like the S&P 500 to provide a hedge against the stocks they own.

Unfortunately, this technique tends to be very difficult and expensive to implement. Buying these options is a bit like buying a very expensive six-month fire insurance policy on your home. As long as your home burns down in six months, buying the insurance is a good idea.

But if the "house" doesn't burn, you'll be faced with the choice of buying another expensive insurance policy or going without it. The longer you continue to buy these policies, the more you consume valuable investment capital.

Another common drawback with a put option hedge is that you never know when to remove it. For example, even if the market fell 10% shortly after you purchased your options, you would face a quandary: Should you bag the profits on your options and close out the hedge? Or should you let it ride?

If you sold your options, you would book a profit on them, but then the market might continue falling and you would have no hedge in place. On the other hand, if you held on to your options, the market might recover and your options would expire worthless.

3) Buy call options. Buying call options provides a very different kind of hedge. Unlike put options, call options don't produce gains in a falling market. However, they do limit losses, which can be a helpful benefit.

One way to use call options, therefore, would be to establish a new position in a stock you wish to own.

For example, instead of paying $30 a share to buy "Stock X," you might pay $3 to buy a one-year option to purchase the stock at $30. If the stock rose, your option would deliver sizable gains. On the other hand, if the stock fell, your option would expire worthless.

But the good news is that you couldn't lose more than the cost of your option - i.e., $3 a share. So even if the stock tumbled all the way down to $20 or $15, your maximum loss would still be $3.

Limiting your downside risk in this fashion can be a great way to invest in a market that is as pricey as ours is today.

4) Sell stocks short. This tactic can be a very dangerous one, as the risk on a short sale is literally unlimited. A stock you have sold short (i.e., bet against) at $20 a share could soar to $40... or $60... or $100.

That's a serious risk.

On the other hand, a short sale doesn't have a "shelf life" like an option does. It has no expiration date. So as long as the short sale isn't causing any harm, you could maintain that position for months or even years at a time.

Additionally, it is possible to generate a positive return from a short sale, even if the overall market is going higher.

But be forewarned: Short sales can be very, very dangerous. Only savvy investors should attempt them. A short sale is never an investment; it is always a trade. But as a trade, a short sale can provide a valuable hedge to your long-term investment portfolio.

To Hedge or Not to Hedge?

So where does that leave us?

It leaves us with the observation that hedging effectively is very difficult to do. Because of this fact, I believe most investors should simply map out a realistic investment course and then stick with that course through thick and thin.

If an investor is overly fixated on near-term gains and losses, that investor will lack the patience and staying power to allow an excellent investment to work its magic... over the long term.

Consider this real-world example of one well-known stock...

If you had purchased this particular stock 30 years ago, you would have endured the following setbacks:

  • 23% of the time, your stock would have produced an annual loss.
  • 8% of the time, your stock would have produced a three-year loss.
  • On one occasion during those 30 years, your stock would have spent an entire decade producing a loss.

And yet, despite these setbacks, this particular stock produced a spectacular 30-year return of 8,967%!

This particular stock was Berkshire Hathaway (BRK.A) (BRK.B), the investment vehicle that made Warren Buffett a multibillionaire... and made millionaires out of many ordinary investors...

Clearly, a thoughtful, long-term investment approach can reap rewards that boggle the mind.

Disclosure: We expressly forbid our writers from having a financial interest in their own securities recommendations to readers. All of our employees and agents must wait 24 hours after online publication or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Investment U should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

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