Hedging for Beginners

Last week the The Digerati Life, a generally worthwhile blog, had a generally worthwhile post on market timing. (Bottom line: you really shouldn’t.) But NYSE floor Old - Cropit had a few sentences I keep rereading.

I have in my portfolio two ETFs that track the movement of the Dow. One makes money when the market goes up and the other makes money when the market goes down. The only job of these ETF’s is to react to the overall market. The responsible thing that I do is to buy them both as a form of insurance. I buy both because I know that I cannot predict the market movements.

So Silicon Valley Blogger owns two ETFs that exactly mirror each other, such that the net of the combination of the two is zero? (Actually, it would be the T-bill rate less the management fees, which is approximately zero but maybe less.)

That can’t be right. She didn’t mean that. That would be dumb.

With the market warming up but still plenty scary, now is as good a time as any to go over the basics of hedging. A hedge is basically an insurance policy, something you do to get rid of a risk you got as a side-effect of something else you did want to take on. You like driving a car, but you don’t like the risk it will be totaled in an accident, so you buy collision insurance.

In stock market terms, let’s say you were really keen on the prospects of Toyota and the car business in general. So you buy some of the company’s stock. But that exposes you to the Japanese stock market and to the Japanese Yen. If either goes down in value your Toyota stock will probably also go down, even if your predictions of Toyota’s success turn out to be true.

So you hedge by selling short an ETF linked to the Japanese stock market. Since this position will make money when the Japanese market or Yen goes down, you will have insured yourself against the risks you don’t want, while keeping your exposure to what you do, namely the future of Toyota. (Do I need to explain shorting also? Perhaps in another post. When you short you borrow the shares and sell them. Instead of owning the shares you owe them, so your payoffs are perfectly flipped around.)

If you are picking individual stocks to invest in, something I personally enjoy but do not recommend as a way to make money, then you may have the problem of too much exposure to the stock market. There are ten stocks you really like, but after investing in them your overall equity allocation is too high, say 60% of your overall investments when you’d be more comfortable with 40%. No problem. Just short the market, for example using Spyders (SPY) to the value of 20% of your portfolio.

But if you are not picking stocks, for example just investing in index ETFs or mutual funds, then hedging is probably not for you. If you own a large block of Vanguard’s 500 Index Fund, but are concerned about the market, don’t short some Spyders. That would nicely cancel out some of your 500 Index position, but cost you an assortment of fees. Better to just sell some of the 500 Index Fund.

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