Five ways you may be able to protect some of your recent stock market gains-5iResearch
Peter Hodson: Here are five ways you may be able to protect some of your recent stock market gains
Author of the article:
Jan 22, 2021
With markets continuing to work higher and higher, we are
getting lots of questions from customers on how to protect their nice
embedded gains in the stock market. At our hedge fund, hedging is also
of course very important. But many investors are not familiar with
hedging strategies, and there are many. Let’s take a look at five ways
you may be able to protect some of your recent stock market gains. Some
have big drawbacks, and all but one carries some significant risks.
are surprised when we tell them the best hedge is usually cash. We are
positive on markets (and why not — they have risen for more than 100
years) and we typically suggest investors hold only enough cash to reach
the ‘sleep at night’ level. We cannot predict the market, and neither
can you. ‘Going to cash’ is never a good idea, but holding some cash so
you don’t panic in a bad market is never that bad of an idea, either.
Cash doesn’t cost anything, and even earns a minuscule amount. More
importantly, cash does not go down if your hedge does not work. If the
market goes up, your cash is still there. Most if not all other hedges
will lose money when the market goes against you. Most other hedge
products carry borrow fees to short or management fees. Cash does not.
Cash of course is also the most flexible and liquid security if you
change your mind on the hedge and find an attractive investment
Short selling indices
way to protect your portfolio from a decline in the overall market is to
short the market, using ETFs such as SPY for S&P 500 exposure, or
QQQ for Nasdaq exposure. If one is not comfortable shorting, one could
buy an inverse ETF such as SH which will rise if the market declines.
Most investors are scared of shorting, because if one short sells a
single company then potential losses have no limit (think of someone
shorting Apple years ago at $7). But shorting a market index is not
nearly as risky. Sure, markets can move against you. But an index cannot
be taken over at a premium, and owning dozens or hundreds of stocks in
an index product dramatically reduces single-company risk. Shorting an
index is simply an easy hedge against a market decline. The drawbacks
are costs — it costs money to short — and also one needs to cover
dividends. The dividend on the S&P 500 is 1.5 per cent right now.
With shorting costs, the market likely needs to drop about five per cent
for this hedge to be successful. Inverse ETFs do not cost anything more
on their own, but have high management fees. SH’s fee, for example, is
0.89 per cent. While we are on the topic, while we think single inverse
ETFs are ‘OK’ for hedging, we would advise all investors to avoid
double- or triple-leveraged ETFs like the plague. These are toxic
In pair trades,
rather than selling a stock you like, you short sell a company you like
‘less’ within the same sector or index. Suppose you own Facebook, for
example, you could short sell Snapchat shares as a hedge. You still take
on the individual company risks in shorting, but in this case your two
positions are in the same sector, so you do eliminate sector risk. In
addition, while most investors find fundamental analysis difficult, they
find it easier to say, “this company is better than that company”
overall. Another point is this avoids the tricky issue of valuation:
Even if the sector you are pairing is massively overvalued, it won’t
matter as long as your ‘good’ company outperforms your ‘bad’ company.
Many investors will buy put
options to protect positions. Certainly these can work as a hedge, but
this strategy can be very expensive. Suppose you have made a lot of
money on Tesla (TSLA on Nasdaq). Many investors have, as the stock is up
677 per cent in a year. As we write this, the stock is US$850. But a
February US$850 put option, which expires in 28 days, will set you back
US$71.00. This gives you the right, but not the obligation, to sell
shares at US$850. An investor needs to pay 8.3 per cent for one month of
insurance on the stock. If Tesla shares are above US$850 on Feb. 19,
this option will be worth $0, and another put will need to be bought to
maintain a hedge. Now, supposed one wants a longer term to hedge. The
Tesla March 2022 US$850 puts will today cost you US$272 per contract.
This is a 32 per cent insurance premium based on the current price of
the stock. Could shares fall that much? Sure they could. But if they
don’t, you’ve just lost 32 per cent, and shares have to rise above
$1,100 for you to break even now on the hedge.
Selling ‘in-the-money’ calls
investors do not know about this strategy, but it is one of the better
ones. Suppose you own Netflix (NFLX on Nasdaq). It is near US$600. Maybe
you have owned it for five years, at a cost of US$100. Rather than
shorting the market, buying puts, or shorting a pair trade in, say,
Disney, against the position, one could sell a June US$550 call option.
Because you own the stock, this is a covered-call position. One can get
US$78 currently for this option contract. If the stock is still above
US$550 by June, you will have to sell it. But since you got US$78 for
the contract, that’s the same as selling it at US$628 (US$550 plus
US$78). In this hedge the stock can decline by a decent amount and you
still make money. There is still risk: if the stock drops below US$550
you are still going to own it. There is also a potential tax hit if the
stock is called away (one can buy the option back to prevent this,
however). For this hedge you are basically selling time to nother investor, as your own hedge.
Hodson, CFA, is Founder and Head of Research at 5i Research Inc., an
independent investment research network helping do-it-yourself investors
reach their investment goals. Peter is also Associate Portfolio Manager
for the i2i Long/Short U.S. Equity Fund.