The Daily Breakdown looks at different hedging strategies involving options, inverse ETFs, and raising cash.
Friday’s TLDR
- Hedging can be simple or complicated
- An example of when to take profits with Costco
How to Hedge
With the recent volatility and after a few disappointing earnings reactions, some investors are exploring ways they can adapt or approach markets when volatility shifts higher. That makes sense after back-to-back years of 20%-plus gains in the S&P 500 and 120%-plus gains in Bitcoin.
Hedging
Investors hedge to protect their portfolios from potential losses due to market fluctuations. For instance, if an investor is long a stock or ETF, they may look for ways to mitigate their exposure for a certain period of time — like after a large rally or before a big event like earnings.
There are actually several ways to go about hedging.
First, “reducing exposure” can be as simple as reducing the position size. For example, selling 20% of the position keeps an investor involved in the position but lowers their exposure and moves that capital into cash — a safe-haven asset not prone to volatility.
If an investor wants to hedge but doesn’t want to sell any of their positions, there are other considerations.
For instance, inverse ETFs — which are designed to go up when the underlying asset price goes down — are available on popular funds like the S&P 500 or Nasdaq 100, as well as a handful of individual stocks. Some of these funds also have a multiplier effect, such a 3x leveraged ETF. For instance, some popular ETFs include SQQQ (3x leveraged Bearish Nasdaq 100 ETF) and the SOXS (3x leveraged Bearish Semiconductor ETF).
Warning: These ETFs do not tend to perform well over long stretches of time and are meant as short-term trading vehicles.
Finally, hedging can be done with options. For those familiar with these products, put options or put spreads can be purchased to capitalize on a move lower in the underlying stock.
For example, someone who is long Apple could purchase puts or put spreads, which could profit in the event that Apple shares move lower. This could be a speculative play from an investor who is bearish or it could be a hedge from someone who is long.
You can find out more about options trading with our free Academy courses and more specifically, find out more about hedging here.
Don’t Forget the Bigger Picture
Ultimately, don’t forget the bigger trends that are in play. Markets have done quite well over the past two years and the big catalysts — like earnings growth and the economy — remain on solid footing.
But that doesn’t mean we can’t have some periods of volatility or some pullbacks along the way. In fact, it would be weird if we didn’t!
Long-term investors can either endure these dips along the way knowing it’s part of the ride, or they can be more active and try to mitigate those losses. There are no free lunches on Wall Street, as hedging has its costs, too. But sometimes it can pay to be a bit defensive.
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Managing the Trade — Costco
This example is for educational purposes only and should not be taken as advice.
I want to look at Costco, a stock we talked about in January. Shares have traded quite well since clearing downtrend resistance. This is a good look at when a trade works out well.
Notice the risk/reward tool we’re using on the right side of the chart. (On the charting page, this can be found on the left-hand side under “Projections” and the tool itself is called “Long Position”).
The tool shows an entry at $920, with a stop just below the recent low of $900. In this case, the stop-loss is at $895.
Investors often target something like a 2-to-1 or 3-to-1 risk/reward ratio. Meaning that, for the $25 a share in risk the trader is taking — such as in this Costco example — they are seeking a reward of $50 a share (in a 2-to-1 situation) or $75 a share (in a 3-to-1) situation.
Of course, a trader can use whatever ratio works best for them. In this case, a move back to recent resistance near $1,000 was a little more than a 3-to-1 risk/reward ratio.
Taking Profits
If a rally of this magnitude was the trader’s goal, they could consider exiting the position completely or taking some profit off the table and potentially raising their stop-loss to protect their remaining profit.
For those that do take some but not all profits off the table, remember that the stock can keep on going — like Costco is doing right now — or it can lose momentum and pull back, potentially hitting the trader’s stop-loss along the way.
Disclaimer:
Please note that due to market volatility, some of the prices may have already been reached and scenarios played out.
