Hedging a Stock Portfolio

We have all heard the experts recommend "hedging" your stock portfolio. You may have meticulously researched and selected all of your portfolio longs as your core holdings for long-term appreciation. You have performed due diligence on each company’s fundamentals, its management, the news, the analyst opinions, and even the charts – and you are confident that your stock portfolio is positioned to outperform the major indexes. But you worry that a major market downturn will take your high-quality stocks down with it, so you would like to create a hedge against such an event. Let’s compare a commonly used hedging method with the “hedge basket” strategy that we prefer here at Sabrient.

One of the most common approaches is to buy out-of-the-money (OTM) put options – either on the individual securities or on a representative index like the S&P 500 (or SPY). This approach is very much like buying an insurance policy, i.e., you pay the premium in case everything goes awry, and you hope that the protective puts expire worthless. Some practitioners will also write OTM covered calls on their stocks, using the premium taken in to buy the protective puts in something close to a “premium neutral” transaction. This is called a “collar.” However, it is more effective for capital preservation than for letting your portfolio grow, since the covered call effectively limits your upside potential.

A better approach is one to which Sabrient adheres. It is a “hedge basket” strategy, much like an absolute return long/short strategy. In an absolute return strategy, you purchase a basket of stocks that you think are fundamentally strong and likely to rise, and then you sell short a basket of stocks that you think are fundamentally weak and likely to fall. On balance, you are aiming to capture the performance spread between the two stock baskets with the expectation that your basket of longs will outperform your basket of shorts.

Similarly, a hedge basket strategy seeks to identify a group of stocks that are likely to underperform the stocks that you hold long. You can either sell short that basket of stocks or buy put options on them with sufficient time to expiration (perhaps 2-6 months out).  So, if everything goes as planned, you can seek to make money on both your long portfolio and your hedge basket. Doesn’t that sound like a better objective than actually hoping a basket of puts on your favorite stocks all expire worthless – forfeiting the entire premium paid for the sake of portfolio insurance?

Retail investors might look to Sabrient’s Investor’s (H)Edge Portfolio (http://InvestorsHedge.com) for ideas on putting together a “hedge basket” of shorts or put options. Investment professionals should contact us directly for consultation on a custom solution (http://sabrient.com/institutional.php).