Though there’s a price attached, a timely hedge provides insurance that, if you need it, can be well worth the cost.
Hedging ETF with options
Equity options contracts on ETF’s are among the most convenient ways to hedge since options are relatively inexpensive and highly liquid. If you buy an option, which makes you the owner or holder, you have the right but not the obligation to exercise it. Call options give the right to purchase the product underlying the option — such as shares of an ETF — at a certain price by a particular date. Put options give you the right to sell the underlying product at a set price by a certain date. In contrast, if you sell a call, you’re obligated to sell your shares if the contract holder wants to buy. And, if you sell a put, you must buy if the holder wants to sell.
The amount you pay for the right granted by the option is called the premium, and it fluctuates based on demand for that option and the time remaining until the option expires. But the premium is never as much as the cost of purchasing the underlying product. That’s one reason options can effective strategic tools — though they are not suitable for every investor.
Example of options hedge
If you own an ETF you think may decline in value because the index it’s linked to may drop, you might purchase a put options contract on the ETF. If the share price falls, the option gives you the right to sell your shares at a predetermined price that’s better than its market price any time before the option expires.
If the index does in fact decline, you can put, or sell, shares at the option price and limit your loss, which otherwise might be much greater. If the index doesn’t decline, you can simply allow the option to expire and keep your shares. If they rebound over the long term, you will be in a position to benefit from the gain.
Using a somewhat more complex approach, you might hedge a portion of your portfolio of individual equities by purchasing a put option on an ETF linked to the benchmark index for that segment of your portfolio. For example, if you owned several technology stocks included in the Nasdaq 100, you might buy a put option on the ETF known as the QQQ. You might also hedge a concentrated position in a single security, such as your own company’s stock, by purchasing a put on an ETF linked to the appropriate benchmark.
As an alternative, you might sell covered calls on an ETF you own, pocketing the cash from the premium to lock in a profit or protect against mild losses. With this approach, though, you do limit your opportunity to benefit from unexpected gains if the value of the ETF increases and the option holder exercises the right to buy your shares.
Options hedge risks
When you buy index options, you put your premium at risk. For example, the price of the underlying product could move in a different direction than you expected or could change more slowly than you anticipated. Since, in these cases, the contracts can’t be exercised or sold for a profit before they expire, you’d lose your premium.
In fact, options premiums lose value as the contract’s expiration approaches, a characteristic of options contracts known as time decay. Their value is also affected by changes in interest rates and market volatility, which you can’t always anticipate.
You can also hedge with ETFs by selling short in anticipation of a price decline. For example, if you own a portfolio of small-cap stocks and fear that this market segment may experience some short-term losses, might sell short shares of an ETF that tracks small-caps.
To sell short you borrow shares from your broker through a margin account and sell them at the current market price. Your goal is to buy back the shares at a lower price within a relatively short time and return them to your broker. You’ll also pay interest and transaction expenses.
If the strategy works, you will realize a profit in the difference between the price you sold the shares for and the cost to buy them back. That profit can offset losses in your portfolio that result from a falling market. What’s more, since you can transact a short sale as a share price drops — called a downtick – you can enhance the likelihood that your hedge will perform as you anticipated.
Of course, you could sell your small-cap stocks outright and reinvest the money elsewhere, but that might generate unwanted capital gains. And, if you feel the small-cap downturn is temporary, you may want to hold onto your investments to benefit from any future increases in value.
Short sale risks
Shorting any security is risky. Beyond the transaction costs to buy and sell, plus the interest you pay on the borrowed shares, there’s always the chance that the market will defy your expectations, and the shares you sold short will go up instead of down. It will then cost you more, perhaps a lot more, to buy back the borrowed shares. Even if your portfolio gains value because the overall market is going up, it may not increase enough to offset the cost of the hedge, so that you end up actually losing money in a rising market.
Identifying the appropriate ETF to hedge the stocks adds another layer of risk. The key is to find an ETF whose underlying index mirrors the portfolio holdings you’re trying to protect. Otherwise what happens to the shares of the ETF won’t reflect what happens in your portfolio and you may not offset any of its declining value. And unless it’s a perfect match — which is unlikely — you will always face the risk that the ETF and the shares you are trying to protect won’t move exactly the same way.
A double hedge
There may be times when you think a single hedge isn’t enough protection. In that case, you might sell an ETF short because you expect the index it tracks to drop. At the same time, as insurance against a rise in the index, you might buy a call option on the same ETF. That will give you the right to buy shares at a specific strike price that you can then resell at the higher market price. Whichever direction the index moves, you are in a position to limit your losses and perhaps make a small profit. However, the additional commissions you pay with a double hedge increase your costs and reduce potential profit.
Pros And Cons Of Most Popular ETF Hedging Strategies by Inna Rosputnia
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