Welcome to our Options Trading Tutorial. Options trading is all about understanding leverage and trying to get the highest return investments to pay out in the shortest amount of time. You'll find that in this tutorial we delve into other related topics where leverage is important in order to improve your understanding of why options trading in most cases offers a better trading experience than other forms of trading.

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Tuesday, June 14, 2011

How to Hedge Stocks

Knowing how to hedge stocks owned in a portfolio is one of the most important aspects of maintaining a portfolio of equities. Figuring out how to hedge stocks in your specific portfolio will be a different problem than how I hedge stocks in my portfolio - as our investments and timeframes will differ. Here are some guidelines as to how to hedge stocks in your equities account based on what types of securities you own and how long you intend to own them.

How to Hedge Stocks Held for Long Term

Long term investments have higher duration risk, and unfortunately that means higher cost when it comes to insurance (a.k.a. hedging). At today's interest rates borrowing costs are relatively low which makes valuations on future cash flows to be fairly expensive based on discounted cash flow valuation methods. In other words cash flows in the future are worth almost as much as cash flows today. When rates are higher, future cash flows are worth much less than cash in hand today. What does that mean for long term insurance of equities? Bad news. An insurance contract on a long term fixed dollar value payout (based on the value of the stock today) will be more expensive than a similar contract would be if rates were higher.

In a case like this it may pay a little attention to the volatility indicator (see Trading the VIX). As the volatility indicator falls, the part of the premium on general stock options contracts falls as well. Leaps (a long term stock options contract) are less expensive with a low VIX (all else equal). If you are going to buy insurance on long term securities, odds are you will buy leap put options on your stocks at the strike price you wish to receive should the market tank on you. They will generally be expensive, and the spread will also be wider than short term hedges.

How to Hedge Stocks with Reduced Cost

In the above discussion what did we say added to the cost of hedging stocks? Lower interest rates? Higher volatility? Higher stock price? Longer duration? Howabout all of the above. So how do you reduce the cost of hedging stocks? Howabout changing the conditions mentioned above that raise the cost?

You have no control over interest rates, so that's out (although today they are as low as they can conceivably go, so nowhere to go but up... if that ever happens...). What about lowering volatility? Although you have no control over it, you can decide WHEN to buy your insurance, and interestingly enough that as your stocks are highest, volatility will typically be lowest, and hence that is a favorable time to hedge stocks.

What about those higher stock prices then? If volatility is low and stock prices are high (those two things usually go together), do you absolutely HAVE to hedge the ENTIRE current value of your stocks? Can you live with hedging perhaps your capital investment plus a 10 or 20% gain (presuming you have gains > 20% on your present holdings)? Reducing the overall AMOUNT of the hedge is the most direct way to reduce the cost of hedging stocks.

Using Shorter Duration Options to Hedge Stocks

Shortening the duration of stock hedges in low rate environments like today has a dramatic impact on reducing the cost of hedging. The time/duration premium on options contracts is much higher in a low rate environment than it would otherwise be. Shortening the length of the options contract bought reduces the length of coverage, true, but it also dramatically reduces the cost.

How to Hedge Stocks Held for Short Duration

Here is where the choices become significantly more interesting. Once the target holding period of an equities position drops to a month or two, the number and variety of available contracts to use as a hedge opens up dramatically. Among the more interesting choices are one-touch options and barrier options. Unfortunately these contracts are only available on the most liquid securities, but if you're holding shares of Microsoft or Apple that you plan on liquidating after a certain number of days and want to lock in today's high prices, a one-touch options contract might serve you well. Sadly these aren't widely traded yet, and aren't available on most stocks, but in most cases a simple one or two month options contract will do - and most stocks have something out there that can be traded/bought for hedging purposes.

I know that doesn't cover every scenario known to the market, but hopefully that gives you some idea of how to hedge stocks in your portfolio, and what sort of tools you have at your disposal, and what sorts of market conditions are likely to impact the cost (and therefor effectiveness) of your stock hedging efforts.