“Hedging” is a term you may have heard before, but you may not know too much about it. One thing to know is it’s not to do with your garden. So what is “Hedging”? It is a useful practice that all traders and investors should know and implement. Hedging is a way to protect your portfolio. There are two main aspects to hedging. Firstly, it helps to offset losses. Secondly, it reduces your risk. Let’s take a deeper look.
Its like insurance
One way to think of hedging is it being a form of insurance. You can insure your portfolio against negative events of the market by hedging. This will help reduce the negative performance you may experience in a fearful market. With house insurance or car insurance, you prevent yourself from incurring major losses. But insurance doesn’t mean you don’t experience bad events. Similarly with your portfolio, a hedge will help reduce losses when the market sells off. The stock market will always fluctuate. There are ways to protect yourself against intra-day volatility, weekly uncertainty or a complete bear market.
Large cap investment hedges
Banks and investment funds will always use hedges to limit their risk. But what can you do as an individual to cover yourself? Traders can choose to hedge using securities that have negative correlations to their positions. For instance, if you are an investor who trades large cap companies such as Apple, Microsoft, Amazon and Tesla, the S&P500 is a security you can use as a hedge. If these large cap companies are selling off, your portfolio will be incurring losses. But there is no need to sell your investments and wait for things to change sentiment. Shorting the S&P500 would help offset losses. As these companies drop in price, so will the S&P500. In the UK, you could take a leveraged short position on a spread bet or CFD. In the US, buying a put option would help protect you from large downside moves.
Small cap trading hedges
For day traders and swing traders in the small cap markets, the VIX (Volatility Index) can be used as a hedge for your current positions. VIX is a real-time market index representing the market’s expectations for volatility over the coming 30 days. As fear and uncertainty enters the market, small caps are early to sell off and see much more downside compared to large caps. The VIX will rise as small caps sell. This allows you to take a long position to cover as your swings drawdown in price. What can also help is then playing the backside of this movement as things ease. You could switch and go short as the market strengthens and volatility drops. This means a hedge against a drop in your portfolio and also a very strong bounce as smaller companies recover quickly and you are making money on the drop in volatility.
Whatever stocks you are in, there will always be movement in price. This movement is what provides opportunities, wether it is on the long side or the short side.