A Guide to Hedging for the Amateur Investor: Part I

Specialist Anthony Matesic works on the New York Stock Exchange's trading floor on May 23, 2022. David L. Nemec/New York Stock Exchange via AP

Commentary 

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. That’s not a problem because no one is born knowing these things, and these topics are rarely discussed in detail on popular finance shows. Let’s go over some of the basics of how to think about hedging, and along the way, we’re going to show you some of the specific ways we address risk in our own portfolio.

This can be a complicated topic, so if you want more detail or have follow-up questions, just post something in the comments. I’ve found that if one reader has a question, others will as well. It’s ok to not know the answer, and admirable to want to know more.

What Is Hedging

Hedging is taking a position to reduce a specific risk in your portfolio, or buying insurance against risk. For example, homeowners carry insurance in case of fire, or some other disaster that could destroy their home, or cause substantial damage. In flood zones, homeowners buy separate flood insurance to protect against that particular loss.

Professional investors do the same thing. We look at our portfolio, the stock market, the economy, and other related factors, and try to figure out what issues might come up that would cause us losses. Then, we design “hedges” (or insurance) to protect us from those potential problems. Let’s go over some examples.

Market Hedges

I’ve been clear since my first article in this paper that I expected inflation to lead to higher interest rates and in turn, to lower stock prices. There are multiple ways we could have managed this risk:

• We could have sold our existing stock positions. Exiting the market can be a fine solution when you expect negative returns.
• We could short market indexes like the S&P 500 (ticker: SPY) or the NASDAQ 100 (ticker: QQQ). We did this and it’s been our largest profit producer all year. (More on shorting stocks below).
• We could buy puts on market indexes like the S&P 500. We did this and it’s provided a huge return on capital. (More on buying puts in Part II).

Any of these would have been fine strategies depending on your situation, your portfolio, and your risk tolerance. We’ll go through some of these options in more detail:

Is Shorting Stocks Risky/Dangerous/Hard/Wrong

Many market participants act like shorting stocks is some sort of forbidden, ultra-risky, arcane activity that’s not appropriate for regular investors (and sometimes, for anyone). Shorting stocks is simply buying a stock in reverse. Everyone is used to the idea of buying a stock, hoping it will go up, and selling it for a profit. When you short a stock, you borrow it and sell it, hope it goes down, and then buy it back at a profit (and return the borrowed shares). Same steps—just in a different order.

Some have argued that this is wrong or un-American. I'd like to know why. When you sell a stock, it’s not because you think it will keep going up. Why is buying then selling ok, but selling followed by buying isn’t?

Others argue that this is risky because losses on a short position can be unlimited. This is technically true, but perhaps misleading. For example, if we own a basket of stocks that we like as long-term investments, and think that the market will decline (as it has since January), we can continue to own those long-term investments, and short market indexes that will go down as the Federal Reserve raises interest rates. (That’s example #2 above). The bet we’re taking is that our individual stock picks will outperform the market which is EXACTLY why we bought them in the first place.

Some people will tell you that we’re taking on unlimited risk and we could lose everything by being short the market. Again, technically true but misleading. By only owning long stock positions, we are risking everything we own in the portfolio. Shorting market indexes against our long positions will reduce our risk (under most circumstances). The most likely scenario is that both our long positions and the market short will rise and fall together (one producing profits and the other losses) reducing the amount of risk we have at a given time.

This is not a hypothetical or academic exercise. In recent months, while the market has gone down sharply due to a rising Consumer Price Index (CPI), our short positions and put options (#2 and #3 above) have produced huge profits offsetting losses from other long positions. When done right, the short positions reduce risk instead of increasing it.

For those of you who haven’t done this before, and find it confusing; no problem—I can explain. Please take a look at the order entry box pictured below. You can see that it’s set up to execute an order for 100 shares of Amazon (ticker: AMZN) at $103.84. The “normal” process would involve clicking the “buy” button in the bottom right, and when you want to exit the position, using the “sell” button.

Remember above when I said that shorting is simply buying in reverse? So, if you wanted to short 100 shares of AMZN, you’d use the “short” button, and when you were ready to exit the position, you’d click the “cover” button. It really is that simple. There are some additional complicating factors that market professionals would consider when executing a short trade, but they wouldn’t be big considerations for people shorting the S&P 500 against their existing stock positions.

Credit: Gary Brode

Let’s go through an example. Say you buy the 100 shares of AMZN at $103.84. You’d have 10,384 invested. As a tech stock, AMZN will be most correlated with the NASDAQ 100 (ticker: QQQ). With the QQQ trading at $366.55, you could short 28 shares of that, and bring your equity exposure back to close to $0.

In my next article, I’ll address hedging by buying put options, and hedging for inflation. I often design hedges (or insurance) for specific risk, individual positions, and entire portfolios so if there are additional topics you’d like me to cover on how to protect your portfolio, just ask and I’ll make this a more regular series.