In case you missed the all caps, this isn’t how to hedge in the event of a sell-off. This is about how to stop the bleeding as the market is in the midst of a sell-off this week and you’re a bit too uncomfortable with your exposure.
At TheoTrade, we teach a lot of preemptive hedging tactics that have very little cost. This allows a portfolio to be hedged all the time and not just when the market starts to sell-off. However, when the market selling off is the exact time that many people start to consider hedging. As a result, it’s important to have a formula in both good times and bad. Luckily, if you’re a member, you have a chance to learn both approaches.
In his chat today, Don Kaufman discussed a formula for hedging a potentially volatile week. Let’s take a closer look at it.
Preparing to Hedge
Before you’re ready to begin placing the trade to hedge, there are a few questions that need to be answered first.
Hedging Step 1: Which instrument best reflects your portfolio risk?
The first question comes down to what major market index or sector represents your portfolio the most. For example, a tech-heavy portfolio may decide to use the Nasdaq 100 index option, futures, or ETF as an instrument. Do you have a 2040 fund in your 401K? Then the S&P 500 index may be the best index option, futures, or ETF to hedge your risk.
Hedging Step 2: What is your beta-weighted portfolio delta?
The second question will likely need to be answered by using a software. In our online classes we use the portfolio beta-weighting feature of TD Ameritrade’s thinkorswim software.
This type of tool can translate your holdings or simulated holdings into a delta using another product that you plan to use as a hedge. For example, this type of tool will estimate how much your portfolio will change with a $1 change in the SPDR® S&P 500® ETF Trust (NYSEARCA: SPY). Beta-weighting to the SPY represents the most common approach for most investors.
Hedging Step 3: What percentage of your portfolio are you hedging?
The last question deals with how much protection you will need. The typical knee-jerk response to this question is 100%. If that’s the case, you don’t need to hedge, you need to sell and go to cash. If you’re plan is to remain long then you’ll hedge something less than 100%. A typical hedge is 30-40% of your beta-weighted delta.
Now that you know your instrument, your beta-weighted delta and the percentage of your hedge, you’re ready to pick your tool.
Hedging Tools
With any job there is a tool and hedging a sell-off is no different. This job has two possible tools to use:
- Futures
- Options
Don’s example today incorporated the use of an option and so this post will focus on that approach. However, we do have a class on how to incorporate futures as well.
Hedging With Options
If you were using an option that would be the most direct way to remove risk in case of a sell-off, it would be a short-dated, deep ITM put option. Here are some general parameters to use:
- Pick an expiration with one to two weeks to expiration
- Pick an option with a -0.85 to -0.95 delta
This morning, Don discussed using the following option contract to reduce the risk in case of a sell-off through Friday.
- 24 SEP 21 $445 Put @ $10
That particular contract fulfilled the above requirements and would fully cover a $43,000 portfolio size for about $1000. If you were only wanting to reduce your portfolio weighted delta by 50%, it could hedge up to an $86,000 portfolio value, and so on. If your account is smaller, you could consider using Micro E-Mini S&P 500 Futures (/MES) options.
If you’re looking for a formula of how to hedge your portfolio based on your desired percentage hedge, the formula in the image below may help.
Conclusion
Hedging is an important part of money management. Those who know what type of hedge to apply and when are miles ahead of those who can’t, won’t or don’t. It’s too hard to make money and it can even be harder for some to keep it. If you make it your goal to outperform the market during corrections, then you’ll be in a much better position to outperform. Hopefully, this insight gets you closer to accomplishing that goal from one of the industry’s best.
Wondering when to hedge? See how unlocking the Vomma Zone can help you better understand when volatility is about to rise.
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