I’ve been seeing a lot of important questions recently from amateur investors regarding some of the more advanced topics in the investing world. Many people have been taught about things like diversification and dollar cost averaging, but don’t really understand concepts like hedging, offsetting different kinds of risk, or shorting stocks. In my first article on this topic, I started to explain some of the basics of how to think about hedging, and explained concepts like market hedges and shorting stocks.
Buying Put Options and What’s a Put Option
Options can be complicated. There’s a lot of math that goes into valuing an option, and on my screen alone, the option order entry box includes designations for basic options, covered, spreads, butterflies, iron butterflies, condors, and iron condors. Believe it or not, these are common options trading strategies and not the menu at a shiatsu massage parlor. For the purposes of this discussion, I’m going to eliminate all of that complexity and help you understand one basic thing you can do to hedge your portfolio.To hedge your portfolio, you can buy put options on an index like the S&P 500 ETF Trust (ticker: SPY). This index trades at about one-tenth the value of the S&P 500. So, if the S&P 500 were trading at $3,800, the SPY would trade around $380. The SPY put options give you the right (but not the obligation) to sell a stock or an index at a specified price before a specified date. To hedge long positions, I bought Sept. 16, $335 strike put options on the SPY. This sounds complicated, but simply means that I have the right to sell the SPY for $335 on or before the close on Sept. 16. If the S&P 500 declines in price, the value of those options will likely increase.
The advantage of owning these options is you can’t lose more than what you paid to buy them. In addition, if I’m correct about the direction of the market, the options will go up many times in value as opposed to the 10 percent seen in a correction or the 20 percent that would mark an official “bear market.”
The downside of using options is if the market goes down, but not by enough, you lose 100 percent of your investment. The other downside is you have a deadline; in this case, the Sept. 16 expiration date. For this reason, I tend to make initial option positions small and accept the possibility of total loss of capital.
This is just like buying insurance for your home. You pay something for the insurance (like the cost of the put option), typically for one year (like the expiration date on the put option), and have a deductible (like buying a put option at a strike price below the current price). But if there’s a disaster, the insurance company will pay you many times over what you paid for that insurance. It’s the same thing with the options. You could lose the amount you paid the insurance company or invested in put options, but in the case of a market disaster, you’ll be glad you had the insurance.
Hedging for Inflation
I’ve written on this topic at length, and my guide on it is available here. The key point is that as I predicted last November, inflation is much higher than most people expected, and is understated by the Consumer Price Index. Anyone who’s tried to buy a house, a car, fuel, or food in the last year has experienced this. Another way of describing inflation is by noting that a dollar today doesn’t buy as much as it used to buy. Given that many assets are denominated in dollars, I wanted to help people hedge for inflation. That just means I was looking for ways to benefit from a dollar that has less purchasing power instead of just being hurt by it. I recommended the following things:- Property: I told people to refinance their mortgages in late 2021/early 2022 before interest rates rose. If you own your home, you’ll be able to pay back that mortgage years later in dollars that have less value. At the time (and still now), mortgage rates were below the inflation rate meaning the bank is booking profits, but losing value on the deal. (Who doesn’t love beating the bank at their own game?)
- Gold: This has been the standard for money for thousands of years and it’s very difficult to increase the supply of gold. My linked guide gives several options for how to buy and own gold, but the easiest is to own the exchange-traded fund (ETF) that tracks the price of gold (ticker: GLD).
- Silver: The secondary standard for money and one with greater industrial use. As with gold, I suggest multiple options and the easiest one is the ETF with the ticker SLV.
- Bitcoin: While Bitcoin has declined with the market, long-term, I see it as a deflationary asset during inflationary times. That’s a fancy way of saying that while more dollars are being printed, which reduces the value of the dollar, fewer Bitcoins are being mined, which protects its value in the future. The safest way to own Bitcoin is with your own storage and private key. If that’s overwhelming for you, you can buy the Grayscale Bitcoin Trust (ticker: GBTC).
- Oil: I like owning well-run major oil companies with already-permitted wells. I don’t like paying insane prices at the gas station any more than you do. You might as well own some oil production and gain a benefit from higher prices instead of just paying more and complaining.
