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How to Hedge Your Portfolio

Learn about the risks, benefits, and strategies involved in portfolio hedging, a tactic that may help reduce the risk of adverse price movements.

How to hedge your portfolio

Hedging is a strategy designed to reduce the risk of adverse price movements for a given asset. For example, if you wanted to hedge a long stock position you could purchase a put option or establish a collar on that stock.

Both of these strategies can be effective when dealing with a single stock position, but what if you’re trying to reduce the risk of an entire portfolio? A well-diversified portfolio generally consists of multiple asset classes with many positions. Employing either of the techniques above on every equity position in a portfolio is likely to be cost prohibitive.

Another alternative would be to liquidate part of your equity holdings, which could partially offset the impact of a stock market decline. Most long-term investors, however, aren’t comfortable moving in and out of stock positions, either because of the potential tax consequences or because they want to avoid having to time their re-entry.

What other alternatives are available for investors interested in hedging a portfolio? Here, we’ll look at a cost-effective method for hedging an entire portfolio using S&P 500® Index ($SPX) put options.

Hedging isn’t for everyone

Portfolio hedging is considered an intermediate to advanced topic, so investors considering this strategy should have experience using options and should be familiar with the trade-offs they involve. Many investors have a long-term horizon and try to ignore short-term market fluctuations. However, hedging may make sense for tactical investors with shorter-term horizons, or those who have a strong conviction that a significant market correction might occur in the not-too-distant future. A portfolio hedging strategy is designed to reduce the impact of such a correction, in the event that one occurs.

How do I select a hedge?

Effectiveness and cost are the two most important considerations when setting up a hedge.

A hedge is considered effective if the value of the asset is largely preserved when it is exposed to adverse price movements. Here, we’re trying to hedge the equity portion of our portfolio against a market sell-off. Therefore, the hedge should appreciate in value enough to offset the depreciation in portfolio value during the market decline. Ideally, the hedge would preserve the value of the portfolio regardless of the severity of the sell-off.

How much would you be willing to pay to hedge your entire portfolio for a certain period of time? Perhaps the answer depends on your belief in the likelihood of a significant market correction. For example, if you strongly believe that the stock market will decline anywhere from 5–8% over the next three months, an effective hedging strategy that costs less than 5% may be worth consideration.

If you have a well-diversified equity portfolio, S&P 500 ($SPX) put options might be a good choice. In addition, options on the S&P 500 Index are considered “1256 contracts” under tax law and offer the following benefits:

  • Favorable tax treatment: Many broad-based index options qualify for a 60% long-term/40% short-term capital gains treatment. Other broad-based index options that qualify include those that overlay the Dow Jones Industrial Average ($DJI), Russell 2000 Index ($RUT), and Nasdaq 100 ($NDX).
  • Cash settlement: All index options are cash settled, which makes the position easier to manage around expiration.
  • Leverage: $SPX put options have a 100 multiplier which provides the potential to offset a substantial decline in the portfolio for a relatively small upfront cost. 1

In order to establish a true hedge on an individual portfolio it may be difficult, if not impossible, to find a single financial product that’s perfectly correlated to your portfolio. In the following example, we assume the equity portion of the portfolio has a constant 1.0 beta to the S&P 500 index. Of course, correlation will vary among individual portfolios.

Now let’s see how you might put a hedge to work.

Portfolio hedge in action

  • You own a $1,000,000 portfolio with high equity concentration. The equity portion of the portfolio is well-diversified and is closely correlated to the S&P 500 (meaning the beta is

1.0), but the beta of your overall portfolio is 0.80 to take into account the other assets in your portfolio, such as fixed income. This implies that when the value of the S&P 500 index declines 1%, the value of your overall portfolio will decline by 0.80% (assume the non-equity portion of your portfolio remains unchanged and the 0.80 portfolio beta remains constant throughout this example).

  • You are concerned that the S&P 500 may sell off substantially over the next three months.
  • You are willing to spend 3% of the total portfolio value (or $30,000) to hedge your portfolio for three months.
  • The SPX is currently at 1407 and the VIX (the average implied volatility of SPX options) is currently at 17.
  • The cost of one SPX 1405 put option that expires in three months is $5,000 ($50 ask price).
  • For this example, we are using the at-the-money strike price to obtain immediate downside protection in the event of a sell-off. The 3% or $30,000 allocated for this hedging strategy is used to purchase a total of six SPX 1405-strike put options:

    $50.00 (ask) x 6 (# of contracts) x 100 (option multiplier) = $30,000 (excluding commissions)

    The table below illustrates how the value of the portfolio would be affected based on the performance of the SPX at the expiration of the three month SPX put options.

    SPX percentage change Portfolio percentage change SPX value Value of six SPX 1405 puts Portfolio value Portfolio value with SPX puts Hedged portfolio percentage change
    +5% +4% 1477.35 0 $1,008,800 $1,008,800 +0.88%
    0% 0% 1407.00 0 $970,000 $970,000 -3.00%
    -5% -4% 1336.65 $41,010 $931,200 $972,210 -2.78%
    -10% -8% 1266.30 $83,220 $892,400 $975,620 -2.44%
    -15% -12% 1195.95 $125,430 $853,600 $979,030 -2.10%
    -20% -16% 1125.60 $167,640 $814,800 $982,440 -1.76%

    Source: Schwab Center for Financial Research. There is no change in the value of the other assets in the portfolio. Data represents value at expiration.

    Let’s walk through the calculations for the instance in which the S&P declines 5% (highlighted in blue in the table):

    • Portfolio percentage change = -4%. This figure takes into account the 0.80 beta of the portfolio (5% x 0.80 = 4%).
    • SPX value=1336.65. This is a 5% decline from the initial value (1407 x 0.95).
    • Value of six SPX 1405 puts = $41,010. This is the value of the puts at expiration (1405-1336.65 x 6 x 100).
    • Portfolio value = $931,200. This is a 4% decline (when taking 0.80 beta into consideration) from the initial portfolio value of $970,000 (taking the cost of the hedge into consideration) ($970,000 x 0.96).
    • Portfolio value with SPX puts = $972,210. This is the value of 6 SPX 1405 puts plus the equity portfolio value ($41,010 + $931,200).
    • Hedged portfolio percentage change = -2.78%. This represents the percent change of the total portfolio from the initial $1,000,000 value ($1,000,000 – $972,210 = $27,790/1,000,000).

    As you can see, this hedging strategy was highly effective, as the value of the portfolio was preserved in all scenarios. The portfolio never lost more than the 3% that we allocated for the cost of the hedge.

    How did I choose the hedge amount?

    It’s important to understand that I didn’t arbitrarily choose a hedge that accounts for 3% of the portfolio value. After conducting some research, I determined that the 3% cost represented the minimum amount that could be spent in order to preserve the value of the portfolio less the cost of the hedge (based on the assumptions listed above). For example, if I had allocated just 1% of the portfolio value and the SPX had declined 0–20%, the portfolio value would have declined 1–15%. So, 1% simply doesn’t provide an adequate hedge.

    How does the VIX affect the hedge?

    At the time that I obtained the $50 ask price on the SPX put options, the VIX was at 17. The VIX represents the average implied volatility of SPX options. If the VIX is higher than 17, the three-month at-the-money options will be more expensive and an equivalent hedging strategy would cost you more than 3%. Of course, if the VIX is below 17 you could establish an equivalent hedge for less than 3%.

    What if cost is a concern?

    If you feel that 3% of the total value of your portfolio is simply too much to spend on a hedging strategy, you may want to consider selling covered calls on some of the individual equity positions in your portfolio to help offset the cost. Because we purchased puts on an index that we do not own, we can’t sell calls on that index without establishing a naked call position. If you are not comfortable with selling calls on your stocks and you are still concerned with the cost, then this strategy may not be appropriate for you.

    Is it worth it?

    The hedging strategy presented above provides an efficient way to hedge an entire portfolio, but is the cost worth the benefit? Some investors may take comfort in knowing that the “worst-case scenario” for their portfolio is being down 3% for the next three months. Others may feel that establishing a short-term hedge is equivalent to timing the market and may therefore elect to focus on the long-term. Regardless of your opinion, gauging the likelihood of a significant market decline may be helpful.

    One way to obtain an approximate likelihood of various SPX price levels is to look at the Delta of the put strike prices that corresponded to the percentage decline levels. The table below shows that at the time our sample hedge was established, the probability that the SPX would drop 5% or more in three months was roughly 27%.

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    Likelihood of SPX Falling
    SPX change 0% -5% -10% -15% -20%
    Strike price 1405 1335 1265 1195 1125
    Delta of strike 0.45 0.27 0.14 0.07 0.04
    Percentage chance that the SPX closes below the strike 45% 27% 14% 7% 4%

    Source: Schwab Center for Financial Research.

    Of course, the more severe declines are accompanied by lower probabilities, but this type of information may help you determine whether the cost of hedging a portfolio is worth it or whether you should ride it out.

    1. With long options, investors may lose 100% of funds invested.

    Hedge Ratio

    Hedge Ratio Definition

    Hedge ratio is defined as the comparative value of the open position’s hedge with the position’s aggregate size itself. Also, it can be the comparative value of the futures contracts that are purchased or sold with a value of cash commodity that is being hedged. Futures contracts are an investment vehicle which allows the investor to lock the prices of the physical asset under consideration at some point of time in the future.

    Hedge Ratio Formula

    Given below is the formula of Hedge Ratio:

    • Value of the Hedge Position = Total dollars which is invested by the investor in the hedged position
    • Value of the total Exposure = Total dollars which is invested by the investor in the underlying asset.

    The hedge ratio is expressed as the decimal or the fraction and used for quantifying the amount of the risk exposure that is being assumed by a person by remaining active in a trade or an investment. With the help of this ratio, an investor can have an understanding of their exposure at the time of establishing a position. The ratio of 0 means the position is not at all hedged and on the other side the ration of 1 or 100% shows that the position of the person is fully hedged.

    When the hedge ratio of the investor approaches towards 1.0 then it shows that their exposure with respect to the changes in underlying asset value goes down and when the hedge ratio of the investor approaches towards zero, then the position will be an un-hedged position.

    Hedge Ratio Example

    Mr. X is the resident of the United States and is working there only. He has the surplus amount and wants to invest the same outside the United States as he is already having a good amount of investment in his home country. For the new investment, he conducted some study of the different foreign markets and after studying he found that the economy of country India is growing currently at the faster pace which is even more than that of the United States.

    So, Mr. X decides that he would participate in the Indian market which is having higher than domestic growth by constructing a portfolio of the equities having the Indian companies in that amounting $ 100,000. But due to this investment in a foreign country, the currency risk will arise as there is a currency risk involved whenever investment is done in non-domestic companies. So there is a concern of the investor over the devaluation of rupees against U.S. dollar.

    Now in order to reduce the foreign exchange risk, the investor decides to hedge $ 50,000 of its equity position. Calculate the hedge ratio.

    • Value of the Hedge Position = $ 50,000
    • Value of the total Exposure = $ 100,000

    So the calculation is as follows –

    Thus the hedge ratio is 0.5

    Advantages

    There are several different advantages of this Ratio providing the opportunity for the investors. Some of the advantages of the Hedge ratio are as follows:

    • Parties which are involved in the practices of the aggressive hedging use hedge ratio as the guideline for the purpose of estimation and optimization of the performance of the asset.
    • The hedge ratio is easy to calculate and evaluate as it involves the use of the two parameters which are Value of the Hedge Position and the value of the Total Exposure
    • With the help of the hedge ratio, an investor can have an understanding of their exposure at the time of establishing a position.

    Drawbacks / Disadvantages

    Apart from the advantages, there are different limitations and drawbacks which includes the following:

    1. Sometimes there are situations when the futures are not present in the currency in which hedger has the exposure. This leads to currency mismatch.
    2. Hedge ratio calculated should be close to the unity for attaining the perfect hedge, when calculated in the same currency. In other words, perfect hedge in a futures contract is the same as underlying currency exposure. However, in real practice achieving perfect hedge is quite difficult.

    Important Points

    • It is used by the investors for comparing the amount of the position that is being hedged with respect to the entire position of the investor.
    • The ratio of 0 means the position is not at all hedged and on the other side the ration of 1 or 100% shows that the position of the person is fully hedged. When the hedge ratio of the investor approaches towards 1.0 then it shows that their exposure with respect to the changes in underlying asset value goes down and when it approaches towards zero, then the position will be an un-hedged position.
    • The hedge ratio is hedged position which is divided by total position.

    Conclusion

    Hedge Ratio is the mathematical formula which compares the value of the proportion of position which is hedged to a value of the entire position. It helps the investor in understanding their exposure at the time of establishing a position. Like, if the hedge ratio that an investor has calculated comes to .60, then it shows that the 60 % of the investment of the investor is protected from the risk, while the remaining 40 % (100 % – 60 %) is still exposed to the risk.

    It is used for identifying and minimizing the risk present in the contract. Parties which are involved in the practices of the aggressive hedging use hedge ratio as the guideline for the purpose of estimation and optimization of the performance of the asset.

    This has been a guide to what is Hedge Ratio and its definition. Here we discuss the formula of hedge ratio along with the example, advantages, and disadvantages. You can learn more about ratio analysis from the following articles –

    Hedge Formula Launch Review – Scam or?

    Home » 94 Answers » Hedge Formula Launch Review – Scam or?

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    Hedge Formula Launch Review

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