11 ways to hedge stock risk

Whether you trade individual stocks, stock market indexes, precious metals (such as gold or silver), or have other investments, there are are various tools you can use to hedge stock-related risks in order to reduce potential losses.

Stocks are a volatile asset class and common shareholders are last to be paid in the event of a bankruptcy. A share represents a share of ownership in a company, so you bear all the risk if the company goes under!

This situation offers major advantages, but it also entails sizeable risks.

Most portfolios are exposed to stocks, which can experience sharp declines, whether individual stocks or the market as a whole, when the market begins to discount a different set of future expectations.

Below, we'll discuss the various tools that allow you to hedge your exposure to the stock market.

How can one hedge - or cover - his/her stock portfolio?

Hedging is used to reduce the risk of losing an investment. Hedging often involves using some type of instrument (eg, a security, a derivative) that increases in price when a particular investment or portfolio loses value.

The profit from the hedge is used to offset some or all of the losses suffered by a portfolio. (Or in some cases, more than all). There are various strategies you can use to hedge certain types of risks.

For example, if you own a stock, it represents linear exposure. Hedging your exposure to equities therefore makes it possible for you to hedge the delta risk.

If you have an option, it represents non-linear exposure, so hedging the exposure to an option may involve hedging the gamma.

Other types of hedging can be used to help offset currency risks, interest rate risks, duration risks, inflation risks, or other "hidden" risks. (Example, having a call on airline stocks is an implicit bet on the price of oil).

How can I cover my stock risk exposure?

Hedging can protect:

• a single stock,
• exposure to an entire market,
• exposure to a specific sector, or
• a specific type of risk (such as inflation, currency exchange rates, duration, etc.).

For example, tech companies tend to last longer. Their cash flows are discounted to be further in the future compared to other types of stocks. This causes structurally higher volatility, which makes them more vulnerable to rising interest rates than most stocks.

So, because of this correlated exposure, a trader may choose to take an OTM (Out-of-The-Money) put option on interest rates or on longer-dated government bonds to help reduce this risk. Or even short a number of long-term bonds.

Many traders choose not to hedge individual stocks, but to hedge the risk of the overall market.

If an individual stock in your portfolio is too risky, you should probably reduce your exposure to this stock. This way, it won't create unwanted volatility by itself, thereby risking excessive capital loss.

What is the best type of hedging that's available?

Hedging at the portfolio level is generally done using an index.

As US portfolios tend to more evenly weighted by large-cap stocks (like most equity portfolios), a hedge based on the S&P 500 index might make sense.

If a portfolio is more tech-oriented, the NASDAQ index might be more appropriate.

If a portfolio has more small-cap companies, the Russell 2000 might be more appropriate.

No index is perfect, but it is possible to establish reasonable coverage using an index.

In addition, since a large number of stocks are included in an index, it is less volatile. Therefore, hedging a global stock index in the form of a put option is cheaper than hedging a single security.

It's not uncommon for a stock to move by more than 5-10% in a day. But this rarely happens with diversified indices.

Buying an option involves paying a premium so that someone else bears the risk for you.

You can also buy something else to help lower your risk. For example, a popular form of diversification involves buying bonds because they perform well in another type of market environment. The same can be said of precious metals such as silver.

Short-selling an asset is a common form of hedging. It carries more risk, but at first glance it is less expensive.

In the case of a put option, you pay a premium, but it is only paid once in the money (ITM). If you buy an out-of-the-money (OTM) option, you still have a risk to bear up to the strike price.

You can also buy something else to help lower your risk. For example, a popular form of diversification is to buy bonds because they perform well in another type of market environment. The same can be said of precious metals such as silver.

Short selling an asset is a common way to hedge. It carries more risk, but at first glance, it's less expensive.

In the case of a put option, you pay a premium, but it is only paid once in the money (ITM). If you buy an out-of-the-money (OTM) option, you still bear a risk up to the strike price.

Hedging is an imperfect art

Hedging is rarely perfect. If it was, there would be little to no benefit to be gained from a portfolio. There is always a risk, and the return is proportional to the risk that is taken.

Good traders and investors will calibrate a portfolio based on the level of risk they want and the volatility they'll accept, and use hedging tools to obtain the desired gain without the unacceptable loss.

Risk will not entirely be eliminated and only part of the portfolio will be hedged.

Ways that you can hedge risk linked to stocks

Some ways of hedging stock risk involve options. Others involve buying or selling something. Or different tactics (such as putting together a portfolio).

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price.

For example, an AMZN 3370 call gives the buyer the right to buy 100 Amazon shares (AMZN) at an exercise price of $3,370 per share.

With a US option, it can be executed at any time before the expiration date, if it is ITM.

With a European option, it can only be executed if it is ITM on the expiration date.

A call option gives the buyer the right to buy a certain amount of the underlying asset (100 shares in the case of a standard vanilla option) at the strike price.

A put option gives the buyer the right to sell a number of shares of the underlying asset at the strike price.

The price paid for an option is called the premium.

Deep OTM options are cheaper because they have less intrinsic value. They have a low probability of ending up ITM, so their price is lower, reflecting the likelihood that they will only have an occasional value at expiration.

Deep ITM options are more expensive because they have more intrinsic value. The more ITM an option is, the more the option begins to act as the underlying asset.

Therefore, from a hedging point of view, OTM options are less effective than ITM options in hedging the underlying asset. This comes at the expense of their price, as ITM options are more expensive than OTMs.

Option hedging is a low-risk means of reducing the impact of a decline (or an unfavorable trend, more generally) in the underlying asset which will lead to a decline in the overall portfolio's value.

This can be achieved with a single option at maturity or with several options.

We will go through each strategy individually. They include:

• Long puts: buying a put option
• Put spread: buying and selling two put options
• Covered call: selling a hedge option
• Collar: buying an OTM put option and selling an OTM call option
• Fence/Dutch rudder: strategy that combines the buying and selling of 4 options
• Short selling
• Diversification
• Cash holdings
• Owning volatility
• Inverse ETFs
• Reducing your position size

1) Buying a put option

Buying a put option is a simple way to cut the risk from the left end. But it is also quite expensive.

Those who sell options usually value them with a slight premium, so the implied volatility of the option is likely higher than its actual volatility.

Let's say you own 100 shares of Moderna, Inc. (MRNA). It is trading at $128 and you want to limit your decline to $100 per share.

In other words, you don't want to risk more than 22% on that one position. For 10 months of coverage, that would cost $3/share, or about $3.60 for a full year. At the current price, this coverage costs 2.8%.

Although in some years this will save you from losing part of your capital, it will also absorb a large part of your profits.

You can also lose an amount less than 22% (the price remains above $100) and suffer an unrealised loss, in addition to losing your option premium.

The breakeven chart looks like this, with a risk capped at a decline of $100/ share and a breakeven point slightly above the current price ($128), as you need gains to offset the cost of the option.

Profitability chart of a long put option

For this reason, many traders and investors choose to limit their exposure to individual positions rather than directly hedge them.

For example, if you have 15% of your wealth in the stock of a company, and watching it drop by 45% or more would be too painful, it would probably be a good idea to diversify.

Many people like concentrated portfolios to keep it simple, or because they think they will get better payouts, or simply out of conviction. But the expected set of expectations is already built into the price, so you can never be too sure about a particular investment asset.

This is why some traders and investors choose not to hold more than 10% of the net worth of their portfolio in any given asset. Some will go further by limiting themselves to just 2 or 3%, although this is more time-consuming.

Of course, limiting the size of positions limits the need for hedging, which can be costly.

When traders hedge, they typically use Out-of-The-Money (OTM) options. They will be cheaper than At-The-Money (ATM) options, but they will not protect a portfolio against initial declines in the asset.

2) Buy a put spread

A put spread consists of being both long and short on put options for a same underlying asset.

A put spread is used to reduce the cost of hedging. A portion of the premium received from the short put option offsets the cost of the long put option.

Continuing with our previous Moderna, Inc. example, if you wanted tighter risk management, instead of a 100 strike put, you could buy a 115 strike put.

This will more than double your premium, from around $340 for one contract to around $800.

Instead, you could sell the put option for a strike price of 90, which would represent a premium of around $170.

The cost of your comprehensive coverage is the difference between the two: $800 minus $170 = $630.

$630 is more expensive than $340. You pay $320 more to potentially save $1,500 more in potential losses.

Meanwhile, the spread of the put option causes your hedge to cancel out at some point. Gains on the long put will be offset by losses on the short put. You'll also be long in the stock (assuming you still own it).

If you have a 115-90 put spread, that means your linear risk exposure on the stock drops below $ 90.

650 $ est plus cher que 360 $. Vous payez 310 $ de plus pour économiser potentiellement 1 500 $ de plus en pertes potentielles.

Dans le même temps, l'écart de l'option de vente fait en sorte que votre couverture s'annule à un moment donné. Les gains sur l'option de vente longue seront compensés par les pertes sur l'option de vente courte. Vous serez également en position longue sur l'action (en supposant que vous ayez toujours l'exposition).

Si vous avez un put spread 115-90, cela signifie que votre exposition au risque linéaire sur l'action revient en dessous de 90 dollars.

Put spread profitability chart

All things considered, you might feel comfortable with this situation depending on your goals.

If, at $128, Moderna, Inc. is trading at a forecasted P/E ratio of 25x, this means its forecasted annual earnings per share (EPS) is $5.12 ($128 divided by 25).

If it drops to $90, it could be because its profits are expected to decline. It could also be due to other factors that have little to do with the company itself, such as rising interest rates.

In this case, the $5.12 per share would give it a 5.7% profitability. The reverse is the P/E ratio (17.6x, or 1 divided by 0.057).

At this point, you might believe Moderna, Inc. is a good stock and be comfortable with not having downside protection.

Looking at it in terms of the probability distribution, the $90 to $115 range is larger. In other words, you are protecting yourself against a significant fraction of the left tail distribution (in this case, around 25% of the expected range of results).

3) The Covered call

A covered call option is when you sell a call option on a stock that you already own.

This limits your gains, but gives you the advantage of having a bit of coverage in the event of a decline.

For example, suppose you want to hedge your Moderna, Inc. position at $140/share. You think this price is relatively high and that it's a good number to sell at if you have the chance.

A covered call profitability chart

A $140 stike call with a 1-year expiration costs around $760. You sell it as part of a covered call option, so you are entitled to this premium.

$760 divided by $12,800 (the price of 100 shares, since there are 100 shares per option contract) is approximately 6%.

So you benefit from a ~9% gain ($140 divided by $128) and you get the 6% bonus. Your total gain is ~15%.

Considering the nature of Moderna, Inc. - which is a defensive type of share - it's not bad.

The downside is that you can't benefit from any profits beyond 15%. Your coverage is also quite weak, since it only protects you against a 6% loss. So a covered call option will protect you from some losses, but not by much.

Should I combine it with a put option?

For this reason, some traders like to combine a covered call with a long put option.

This structure makes it possible to take advantage of the volatility risk premium and the advantages of light hedging associated with a short call. At the same time, it also involves more clearly defined downside protection with the long put option.

This is what we call a collar, which I'll get into in greater detail in the next section.

4) Collar

As mentioned above, a collar involves buying a put option and selling a call option.

It is analogous to the idea of ??a covered call option, in which you forgo the upside to receive an option premium on a stock you already own, while buying the put option.

The cost of the put option is partially or fully offset by the premium received from the short call option.

The put option also allows you to better define both the upside and the downside risks.

If the underlying asset exceeds the strike price of the call option, the call option will result in losses which will be offset by the stock's gains.

If the underlying asset falls below the strike price of the put option, the underlying asset will suffer losses which will be compensated by the put option and the short call option's premium.

The advantage of the collar is that it is more neutral in terms of price. You won't be subject to sharp declines in the underlying asset because of the put option.

You receive income that helps you offset the price of the put option against that of the call option.

Studies have shown that the VRP (volatility risk premium) has a higher Sharpe ratio than the ERP (equity risk premium), arguably more sought after by the competition, giving hedged call option strategies (and some of their derivatives) have higher overall Sharpe ratios than conventional equity strategies.

Stock puts tend to be more expensive than stock calls. This is because people are more risk averse and tend to pay more for puts than calls.

You can observe this behaviour in the volatility asymmetry, which compares the implied volatility of options over a range of strike prices. The higher the implied volatility, the more expensive the option.

Bullish collar profitability chart

5) Fence or Dutch Rudder

A close strategy (sometimes called a Dutch Rudder) is the combination of a covered call and a put spread.

Three options are used as well as a position on the underlying.

• Long position in the underlying asset
• Short OTM or ATM purchase option
• Long OTM put option
• Short OTM put option below the expiration of the other put.

Like the covered call and the collar, the fence is a defensive position.

The trader sacrifices the upside for downside protection. In the case of a stock, the trader can still earn dividend payments (unless the call option is ITM and the other party decides to exercise early to get the dividend).

Closing offers the combined advantages of a covered call and a put spread.

i) The short call option premium provides income.

ii) Protection against price declines thanks to a long put option, partially or fully offset by the short call option.

iii) A further reduction in expenses by short selling a put option at a lower strike price than the first one.

The fence allows you to have a more neutral position in terms of risk, while:

• being able to collect dividends,
• having the opportunity to benefit from a certain price increase, and
• having relatively cheap downside protection by selling two options instead of going long on one.

For Moderna, a short call of 140 / long put of 115 / short put of 90 would have this payout structure:

Fence (Dutch rudder) profitability chart

There is a left tail risk involved in short selling a put option, but, for a value investor, returning to a linear delta-1 position may be a good idea, as the stock has become quite cheap at this price point.

Trading options with the DEGIRO brokerage firm

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6) Short selling

Short selling is an easy way to hedge the risk of certain assets.

For example, let's say you want to own Chevron Corp. (CVX) stocks, but you don't want your portfolio to be too exposed to oil price fluctuations.

You could do this by short selling oil futures or an oil ETF to hedge some of that exposure.

To reduce equity risk, short selling is the cheapest and most efficient way to hedge some of your exposure.

If you short sell stocks for cash, you also get a cash credit in your account. This can reduce the amount you borrow on margin or give you a positive balance on which you can earn interest.

There is also an interest cost associated with borrowing, which can sometimes be very high if the demand is large relative to the number of shares that are available.

For "easy to borrow" stocks, the fees are often 0%-1.5% interest per year. For "hard to borrow" stocks, the fees can be crazy, to the point that short selling is practically prohibited. The percentage of interest can be in the hundreds or even thousands.

Selling stocks or futures short is an effective way to hedge stocks against an expected decline in the short term. Futures contracts can also be used to limit your capital commitment.

Some traders may choose to sell short, combined with a short put option.

In a strong bull market where prices are rising, a trader may wish to reduce his stock exposure while not wanting to lose too much by setting up a covered put option.

If stocks continue to rise, the premium received from the put option will offset some or all of the losses.

The downside, of course, is that once the put option becomes ITM, the short exposure to equities ceases to act as a hedge.

If stocks continue to rise, the premium received from the put option will offset some or all of the losses.

The downside, of course, is that once the put option becomes ITM, the short stock exposure no longer acts as a hedge.

Trading futures contracts with the DEGIRO brokerage firm

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7) Diversification

Different assets and different asset classes have different environmental biases and therefore act differently. Proper diversification will improve your risk vs return ration better than anything else. When stock prices fall, there are other assets or other trades that you can make that will allow you to make money to offset those losses.

This can include nominal rate bonds, inflation-linked bonds (ILB), gold, commodities or certain currency pairs, which can continue to provide you with a income, liquid alternatives, etc.

Also, properly balancing one's asset allocation will reduce one's overall drawdown, among other benefits.

8) Cash holdings

Cash isn't very volatile and is therefore seen as a safe asset (unless you live in South America where the inflation levels of some countries are ridiculous and holding onto cash is crazy). However, the value of cash declines over time, making it a risky asset. In addition, in developed markets, liquidity has no meaningful return.

Central banks will aim for an inflation rate of at least 0%, which encourages people to invest their money so that it doesn't lose its value.

However, holding cash (in a bank, not under your mattress) can be very useful to have options, and never having to worry about margin calls, which force you to sell at the worst time.

Cash allows you to take advantage of times when asset prices have fallen sharply to buy them rather than being one of the many people who have to sell their assets to get cash.

9) Owning volatility

When stocks fall, there are usually large spikes in volatility.

Notable stock declines occurred in 1997 (Asian balance of payments crisis), 1998 (Russian default, LTCM), at the beginning of the 2000s (burst of the "tech bubble"), 2008 (the real estate credit default swap crisis) and 2020 (Coronavirus). See also our article on "The biggest stock market crashes in history".

Possessing volatility is a great way to hedge stocks.

The VIX is a popular implied volatility index of a variety of options on the S&P 500. There are futures, options and ETFs based on these futures contracts, and they usually win when stocks fall in value. Established in 1989 by the Chicago Board Options Exchange, it's also a convenient way to measure volatility.

Volatility, however, is a commodity that tends to lose value over time.

As an example, here is a chart of the VXX ETF, which is linked to the VIX index.

The "slow bleeding" nature of these products is sometimes offset by large profits when a significant risk suppression event occurs.

The upward bumps in 2018 and 2020 shown in the above chart look small but were huge percentage gains.

Volatility is also a component of standard vanilla options. But this is less of a product of pure volatility due to the delta component (i.e. the movement of the underlying asset).

Some exotic options are also used as pure volatility products, such as volatility swaps.

10) Inverse ETFs

Inverse ETFs effectively short certain exposures, which means you can short sell the FTSE or the DAX 30.

Their prices increases when the larger market goes down. But some of them are leveraged instruments, which makes them poor choices for trading beyond the daily period.

Leveraged ETFs theoretically allow you to get more for your money, since you get more hedging capacity with a lower capital commitment. However, leveraged ETFs also contain a downgrading aspect.

They should be handled with care if they are used for any purpose other than day trading. This is because their values ​​are recalculated each trading day.

This is why percentages count more than the value of an index. If the value of an index drops by 20%, a gain of 25% is needed to offset the losses and leveraged ETFs reflect this situation.

For example, if an index goes from 100 to 99, it loses 1% of its value. But if the index goes back to 100 the next day, this represents a 1.01% gain.

A 2x leverage ETF of the underlying index would drop 2% from 100 to 98.

The next day the ETF would gain 2.02% to follow the index (2 times the gain of 1.01%).

However, doing the math following the daily reset: taking 98 multiplied by 2.02%, you only get 99.98.

Additional price movements worsen this tracking error, with greater volatility resulting in a larger spread.

Therefore, these leveraged ETFs exhibit a natural decay pattern that skews the efficiency with which they are supposed to track over the long term, i.e. over a period of more than one day.

If the market goes down and you are long on a 2x or 3x short leveraged ETF, you will make more money than just being short on a 3x short FTSE 100 ETF like XUKS.

But it won't be the 3x that many think they will get unless you limit the holding period to just one day.

The advantage of these securities, however, is that they can be traded in a common stock trading account. You don't need to have an options or futures.

Nonetheless, leveraged securities should ideally be avoided for those with holding periods longer than one day due to the resulting tracking error.

11) Reducing your position size

Having a portfolio that's too focused on something increases the need to hedge it.

If an item represents up to 60% of your portfolio, for example stocks in a 60/40 portfolio, there is a greater risk that that your stocks will make a big dent in your portfolio. And this is especially the case when assets are purchased using leverage.

With instruments such as futures or some ETF products, it's pretty easy to get a single asset to exceed your portfolio size with just a few clicks.

But proper position sizing is part of prudent risk management. In financial markets, the range of known items is generally small compared to the range of unknowns in relation to what is integrated in prices.

This is especially true for stocks and this is reflected by high volatility.

Even limiting position sizing in individual stocks isn't enough, given the high correlation between stocks.

Hedging equity risk can be more effective by diversifying in terms of asset classes, countries and currencies, and not just in terms of stocks.

What type of hedging method is best to use?

More concentrated portfolios will likely require larger and more expensive hedges than well-diversified portfolios.

As with everything, there are pros and cons to consider and nothing will be perfect.

The trader who manages a more concentrated portfolio could use a larger hedge while the more diversified trader already has a reasonably well hedged portfolio.

For many investors and retirement account holders, the bulk of their wealth is held in stocks. Because of the concentration risk, it's a good idea to hedge some of it. Also, if a person has long-term investment horizon, a 30% or more stock market drop won't be as brutal as it is for someone nearing retirement age.

It also depends on the nature of one's portfolio.

If a person invests more in American tech companies (ex: CMCSA, CSCO, FB, INTC, MRNA), the NASDAQ will be a closer representation of their portfolio. The use of a NASDAQ-linked hedge might therefore be better. Whereas for someone who invests in a variety of large-cap companies, the S&P 500 might be a better fit.

A portfolio with higher overall volatility and a higher beta will require more hedging, though.

There are several ways to do this. Put options, as we mentioned, tend to be quite expensive, although they are effective in limiting your losses beyond a certain point. You can limit part of this cost by selling call options on your stocks, but this will limit your gains.

Forming a collar on your position will let you define your gain and decline, and is popular for more concentrated positions.

Selling a put below your long put (forming a "fence") may further reduce hedging costs, but will expose you to a further decline if the price drops to that level (at this time, you might consider that the stock is cheap anyway and worth having such linear exposure).

You can short sell stocks or futures contracts as a cheaper and more direct way to hedge, but this will limit your yields.

Once you have an idea of ??what type of coverage is best suited to your portfolio and investment goals, you need to figure out:

• What is your upside potential? Will it be unlimited or capped (for example, due to a short call option)?
• What's your downside? Will it be capped (for example, by a long put option) or simply limited out of prudence?
• How much is it going to cost?

There are ways to hedge that won't cost you anything - for example, a covered call option, a collar, a fence - but you need to understand if these arbitrages (capped gains) make sense for you personally, and what kind of protection they offer.

The cost of hedging

Hedging your risk on stocks will involve the payment of premiums. These premiums depend on several variables, such as:

• implied volatility
• the price of the underlying asset
• the strike price
• the expiration date/time
• interest rates

The cost of hedging your entire position - that is, an ATM put option - is the most expensive.

For a stock like JNJ (Johnson & Johnson), hedging your entire ATM position (or closest possible maturity to ATM) for six months will cost around 5% of your total position.

JNJ isn't a stock that can be expected to earn 10% per year forever between dividends and capital gains, given its nature as a safe consumer stock.

So it can be difficult to justify the cost of a basic ATM put option. For this reason, traders often use OTM puts to hedge their positions. They don't offer as much protection and it will take time for them to take full effect, if they ever do. But they are cheaper and can be used as protection to avoid a big decline.

OTM put options are also often used in combination with other strategies to reduce their cost.

i) This may include the sale of a call option. If the stock goes up 9% and you would be happy to sell at that price, you may want to consider selling a call option near that strike price. If the stock doesn't reach this price, you have received additional income from the premium.

ii) You might consider selling a put somewhere below your long put option.

iii) You might also consider spreading out the maturities to take advantage of the higher premiums that come over time and selling them while still being long on shorter maturities. (This is an advanced strategy that introduces a shift that adds risk, and should be done with caution).

iv) You may consider overweighting your exposure to short call options to take advantage of the additional premium, which means that you may actually make less profit if the stock goes above a certain level.

For example, for MRNA, which is trading at $128, you could sell a call option at 140 and a call option at 145, in addition to being long on a put option at 115, selling a put option at 90, while being long of a call option at 165 to limit the risk if the stock appreciates significantly.

Your profitability chart would look like this:

This basically looks like a modified strangle.

Conclusion

Risk is an unavoidable part of trading. However, risky things are not inherently bad if they are understood and controlled. But, if the risk isn't taken seriously and what you are doing is misunderstood, it can be very risky. Risk can't be avoided completely, especially free of charge, but hedging is a way to protect a portfolio against potential losses.

Hedging can give traders the peace of mind that they are not exposed to potentially catastrophic losses and help them achieve their goals. Drawdowns are indeed hard to recover from. Moreover, a 50% loss isn't offset by an equal 50% gain. For example, a 25% drawdown requires a 50% gain to return to the breakeven point.

Big drawdowns must therefore be avoided at all costs.

The above strategies, or a combination of them, can help traders maintain their potential for gains while avoiding the risk of suffering unacceptable losses.

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