National Post (National Edition)
WHAT TO DO IF YOU THINK MARKET HAS RUN TOO FAR, TOO FAST.
With markets continuing to work higher and higher, we are getting lots of questions from customers on how to protect their nice embedded gains in the stock market. At our hedge fund, hedging is also of course very important. But many investors are not familiar with hedging strategies, and there are many. Let's take a look at five ways you may be able to protect some of your recent stock market gains. Some have big drawbacks, and all but one carries some significant risks.
CASH
Investors are surprised when we tell them the best hedge is usually cash. We are positive on markets (and why not — they have risen for more than 100 years) and we typically suggest investors hold only enough cash to reach the `sleep at night' level. We cannot predict the market, and neither can you. `Going to cash' is never a good idea, but holding some cash so you don't panic in a bad market is never that bad of an idea, either. Cash doesn't cost anything, and even earns a minuscule amount. More importantly, cash does not go down if your hedge does not work. If the market goes up, your cash is still there. Most if not all other hedges will lose money when the market goes against you. Most other hedge products carry borrow fees to short or management fees. Cash does not. Cash of course is also the most flexible and liquid security if you change your mind on the hedge and find an attractive investment opportunity.
SHORT SELLING INDICES
The easiest way to protect your portfolio from a decline in the overall market is to short the market, using ETFs such as SPY for S&P 500 exposure, or QQQ for Nasdaq exposure. If one is not comfortable shorting, one could buy an inverse ETF such as SH which will rise if the market declines. Most investors are scared of shorting, because if one short sells a single company then potential losses have no limit (think of someone shorting Apple years ago at $7). But shorting a market index is not nearly as risky. Sure, markets can move against you. But an index cannot be taken over at a premium, and owning dozens or hundreds of stocks in an index product dramatically reduces single-company risk. Shorting an index is simply an easy hedge against a market decline. The drawbacks are costs — it costs money to short — and also one needs to cover dividends. The dividend on the S&P 500 is 1.5 per cent right now. With shorting costs, the market likely needs to drop about five per cent for this hedge to be successful. Inverse ETFs do not cost anything more on their own, but have high management fees. SH's fee, for example, is 0.89 per cent. While we are on the topic, while we think single inverse ETFs are `OK' for hedging, we would advise all investors to avoid doubleor triple-leveraged ETFs like the plague. These are toxic products.
PAIR TRADING
In pair trades, rather than selling a stock you like, you short sell a company you like `less' within the same sector or index. Suppose you own Facebook, for example, you could short sell Snapchat shares as a hedge. You still take on the individual company risks in shorting, but in this case your two positions are in the same sector, so you do eliminate sector risk. In addition, while most investors find fundamental analysis difficult, they find it easier to say, “this company is better than that company” overall. Another point is this avoids the tricky issue of valuation: Even if the sector you are pairing is massively overvalued, it won't matter as long as your `good' company outperforms your `bad' company.
BUYING PUTS
Many investors will buy put options to protect positions. Certainly these can work as a hedge, but this strategy can be very expensive. Suppose you have made a lot of money on Tesla (TSLA on Nasdaq). Many investors have, as the stock is up 677 per cent in a year. As we write this, the stock is US$850. But a February US$850 put option, which expires in 28 days, will set you back US$71.00. This gives you the right, but not the obligation, to sell shares at US$850. An investor needs to pay 8.3 per cent for one month of insurance on the stock. If Tesla shares are above US$850 on Feb. 19, this option will be worth $0, and another put will be need to be bought to maintain a hedge. Now, supposed one wants a longer term to hedge. The Tesla March 2022 US$850 puts will today cost you US$272 per contract. This is a 32 per cent insurance premium based on the current price of the stock. Could shares fall that much? Sure they could. But if they don't, you've just lost 32 per cent, and shares have to rise above $1,100 for you to break even now on the hedge.
SELLING `IN-THE-MONEY' CALLS
Many investors do not know about this strategy, but it is one of the better ones. Suppose you own Netflix (NFLX on Nasdaq). It is near US$600. Maybe you have owned it for five years, at a cost of US$100. Rather than shorting the market, buying puts, or shorting a pair trade in, say, Disney, against the position, one could sell a June US$550 call option. Because you own the stock, this is a covered-call position. One can get US$78 currently for this option contract. If the stock is still above US$550 by June, you will have to sell it. But since you got US$78 for the contract, that's the same as selling it at US$628 (US$550 plus US$78). In this hedge the stock can decline by a decent amount and you still make money. There is still risk: if the stock drops below US$550 you are still going to own it. There is also a potential tax hit if the stock is called away (one can buy the option back to prevent this, however). For this hedge you are basically selling time to another investor, as your own hedge. Peter Hodson, CFA, is Founder and Head of Research at 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. Peter is also Associate Portfolio Manager for the i2i Long/Short U.S. Equity Fund.