Pros And Cons Of Most Popular ETF Hedging Strategies

Hedging ETF with options

Equity options contracts on ETFs are among the most convenient ways to hedge, offering affordability and high liquidity. When you buy an option, you become the holder, gaining the right—but not the obligation—to exercise it.

Call options provide the right to buy the underlying asset, such as ETF shares, at a specified price before a certain date. Conversely, put options grant you the right to sell the underlying asset at a set price by a particular date. If you sell a call, you’re obligated to sell your shares if the buyer chooses to exercise the option. Similarly, selling a put obligates you to buy the underlying asset if the holder decides to sell.

The cost you pay for these rights is known as the premium, which varies based on the option’s demand and the time left until it expires. Despite fluctuations, the premium is always lower than the cost of purchasing the underlying asset outright, making options a potentially effective strategic tool—though they may not be suitable for every investor.

Example of options hedge

If you own an ETF that you suspect might decline in value due to a potential drop in the linked index, you could consider purchasing a put options contract on the ETF. This contract would grant you the right to sell your shares at a predetermined price, which could be higher than the market price, any time before the option expires. If the ETF’s share price falls, the put option provides a valuable safeguard, allowing you to limit your losses.

If the index does decline, you can exercise your put option to sell your shares at the predetermined option price, thereby limiting your losses, which could otherwise be much greater. On the other hand, if the index doesn’t decline, you can simply let the option expire and retain your shares. If the shares recover in value over the long term, you’ll still be positioned to benefit from the potential gains.

A more advanced strategy involves hedging a portion of your portfolio of individual equities by purchasing a put option on an ETF that tracks the benchmark index relevant to that segment of your holdings. For instance, if you own several technology stocks within the Nasdaq 100, you could buy a put option on the QQQ ETF. Similarly, you might hedge a concentrated position in a single security, such as your company’s stock, by purchasing a put option on an ETF tied to the appropriate benchmark.

Alternatively, you could sell covered calls on an ETF you own, collecting the premium as a way to lock in profits or protect against modest losses. However, with this strategy, you do limit your potential for unexpected gains if the ETF’s value increases and the option holder chooses to buy your shares.

Options hedge risks

When you buy index options, the premium you pay is at risk. For instance, the underlying asset’s price might move in a direction opposite to what you expected, or it could change more slowly than anticipated. In these situations, if the contracts can’t be exercised or sold for a profit before they expire, you would lose the entire premium.

Moreover, options premiums decrease in value as the contract’s expiration date approaches—a phenomenon known as time decay. Additionally, the premium’s value can be influenced by fluctuations in interest rates and market volatility, factors that are often difficult to predict.

Short selling

You can also hedge with ETFs by selling short if you anticipate a price decline. For example, if you hold a portfolio of small-cap stocks and are concerned about potential short-term losses in this market segment, you might sell short shares of an ETF that tracks small-caps. This strategy allows you to potentially profit from the decline in the ETF’s value, offsetting losses in your portfolio.

To sell short, you first borrow shares from your broker using a margin account and then sell them at the current market price. Your objective is to buy back the shares at a lower price within a relatively short period and return them to your broker. Keep in mind that you’ll incur interest and transaction costs associated with this process.

If executed successfully, you’ll profit from the difference between the selling price and the repurchase cost. This profit can help offset losses in your portfolio due to a declining market. Additionally, by transacting a short sale as the share price drops—known as a downtick—you can improve the chances that your hedge will perform as expected.

While you could also sell your small-cap stocks outright and reinvest the proceeds, this approach might trigger unwanted capital gains. If you believe the small-cap downturn is temporary, maintaining your investments could allow you to benefit from any future recovery in value.

Short sale risks

Shorting any security carries significant risks. In addition to transaction costs and the interest on borrowed shares, there’s always the possibility that the market will move against your expectations, causing the shares you sold short to rise instead of fall. This can result in higher costs to buy back the borrowed shares, potentially leading to substantial losses. Even if your overall portfolio gains value due to a rising market, these gains might not be sufficient to offset the costs of the hedge, leading to an overall loss.

Selecting the right ETF for hedging adds another layer of complexity. It’s crucial to choose an ETF whose underlying index closely mirrors the portfolio holdings you’re trying to protect. If the ETF doesn’t accurately reflect the performance of your portfolio, it may not effectively offset declines in value. Moreover, since it’s unlikely for the ETF and your portfolio to move in perfect synchrony, there will always be some risk that the ETF and the stocks you’re hedging won’t move in exactly the same way.

A double hedge

There may be situations where a single hedge doesn’t provide sufficient protection. In such cases, you could implement a dual strategy: sell an ETF short if you expect the index it tracks to decline, while simultaneously buying a call option on the same ETF. This approach provides a twofold advantage: the short sale aims to profit from or mitigate losses due to a drop in the index, while the call option offers insurance against a rise in the index by giving you the right to buy shares at a specific strike price and potentially resell them at a higher market price.

This combined strategy helps limit potential losses and could even generate a small profit regardless of the index’s direction. However, be aware that the additional commissions and costs associated with both the short sale and the call option will reduce your overall profit, making this approach more expensive.

Pros And Cons Of Most Popular ETF Hedging Strategies by Inna Rosputnia

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