Using Options to Hedge Your Portfolio

With the state of the global economy, many investors are wondering how to protect their portfolios. The following article explains how to protect your portfolio using options and why we all need to protect our investments. This is something we all need to take very seriously.

Why should you hedge?. The answer is simple, you can secure profits long term if you limit your risk.

To understand hedging you must first understand a basic but ignored concept that all investors and traders should know. Equity Beta, which is a calculation of how volatile a stock is when the market itself is moving. Beta shows the sensitivity to overall market movements of an individual equity in your portfolio.

Hedging can protect you from Black Swan Events and other sudden market shifts, it can also allow you to manage your currency exposure.

The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced. So, hedging occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters.

Portfolio managers, individual investors and corporations use hedging techniques to reduce their exposure to various risks. In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year. Hedging against investment risk means strategically using instruments in the market to offset the risk of any adverse price movements. In other words, investors hedge one investment by making another.

Technically, to hedge you would invest in two securities with negative correlations. Of course, nothing in this world is free, so you still have to pay for this type of insurance in one form or another.

Hedging techniques generally involve the use of complicated financial instruments known as derivatives, the two most common of which are options and futures. We’re not going to get into the nitty-gritty of describing how these instruments work, but for now just keep in mind that with these instruments you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Let’s imagine that we own 100 shares of ABCD at $35 and want to hedge this position should the stock decline further. Recent events may have us feeling the stock is vulnerable to the $23 level, which has been a level in past trading where the stock has rebounded. Let’s imagine that shares of ABCD finished trading at $30. In essence, the stock has declined $5 per share since purchase, and, now, we want to hedge that position.

When shares of ABCD open for trading, we may not want to sell the stock and REALIZE a loss. Instead of selling ABCD for a loss, we may want to hedge this position for a period of time using a put option. A hedge like this gives the investor the opportunity to “buy some insurance” on the stock held in his / her account for a period of time.

Let’s assume that we want to hedge into January. Because our example is that a trader owns 100 shares of stock, a hedge would be to buy 1 put contract (1 contract equals 100 shares).

Let’s now assume that the ABCD January $30 put (ABCMF) was offered at $2.30. Let’s assume that the stock opens for trading at $30.

If a trader buys 1 contract, his / her outlay of cash would be $230 plus commission paid. Once the option is bought, our hedge would be as described in the following paragraphs.
We would still hold long 100 shares of ABCD with a cost basis of $35 ($3,500). Once the put option is bought, the trader has established the RIGHT, but not the OBLIGATION to sell his / her stock at $30 between now and the January option expiration (Friday before the 3rd Saturday of January). This transaction costs the trader $230. (Note: A hedge position is considered a “neutral” position.)

Should the stock eventually fall to the $23 level (before option expiration), our 100 shares would be worth $23 ($2,300), but our January $30 put would be worth approximately $7 ($30 strike of option — $23 market price). As you can see, the put option has increased in value; thus, we’ve hedged against the downward move.

If shares of ABCD do fall to $23, and we do not hedge our position, our original investment of $3,500 will be worth $2,300 (paper loss of $1,200).

The hedged position under outlined assumptions would have required a total cash outlay of $3,500 (underlying stock), plus the $230 (cost of option excluding commissions), for a total cash exposure of $3,730. At a market price of $23, the HEDGED POSITION would be worth $3,000 ($2,300 in stock + the now $700 value of put option).

The previous example demonstrated a hedge position on a stock where we were already at a loss. Many institutions and investors will hedge positions that are currently in the position of profit. I would argue that the options market was originally created to allow investors the opportunity to hedge and help mitigate risk, not speculate on stock price direction.

If you are still not convinced hedging is important, take a look at what the OECD see as Future Shocks to world markets.

The Paris-based international economic organisation of 34 advanced nations OECD warns that disruptive shocks are likely to occur with increasing frequency and cause greater “economic and societal hardship” to the international community.

These types of reports serve as a reminder that investors must be vigilant as to their exposure, diversity and hedge positions, for those who need help contact

Pandemics, cyber attacks, financial crises, civil unrest and geomagnetic storms are the top 5 in what the OECD paint as a reason for government and people to be prepared.

The new OECD report, entitled “Future Global Shocks”, says the potential for wide-ranging and destructive consequences transcend national boundaries, given the increased inter-connectivity and the speed with which people, goods and data travel between various countries.

In addition to macroeconomic shocks that traverse globally integrated markets, sudden food shortages, natural disasters and outbreaks of infectious disease may occur in faraway places disrupting various industrial and social systems around the world, it says.

This global community has seen the manifestations of destabilizing elements emerging over the past two years, threatening to jeopardize the political, economic and social stability in several countries.

Recent examples include the ongoing political uprising in the Middle Eastern and North African (Mena) region, and the Euro zone debt crisis, as well as the devastating earthquake and tsunami that destroyed part of Japan in March. There was also the outbreak of H1N1 influenza A virus two years ago that spread to more than 210 countries, with reported deaths exceeding 18,000, before the pandemic receded in the latter part of 2010.

The OECD’s predictions serve as crucial reminders to governments and policymakers of the potential risks and vulnerabilities surrounding the global economy. Governments and policymakers should explore new approaches to international cooperation and greater information sharing to better assess potential shocks and establish prevention frameworks to minimize the negative effects of future storms. it says.

According to the OECD, there’s also a pressing need for policymakers to increase resources allocated to develop effective surveillance and monitoring systems to better manage the oncoming risks.

Director of the OECD International Futures Programme Michael Oborne says in his foreword to the organisation’s report:“There is a palpable sense of urgency to identify and assess risks arising from vulnerabilities in crucial systems, and to develop policies that will bolster efforts for prevention, early warning and response to ensure sustained economic prosperity.

“Visible indicators of vulnerability persist in the forms of economic imbalances, volatile commodity prices and currencies, colossal public debts and severe budget deficits, while the less visible ones are the drivers of vulnerability that tightly weave interconnections between commercial supply chains, technological systems and investment vehicles underlying the global economy.”

Natural disasters, failures in key technical systems or malicious attacks are factors that could disrupt those complex systems and produce shocks that could spread across the world, he adds.

Much of the world’s concern is still focused on the potential risks arising from the social unrest in Mena that could affect oil prices and exacerbate global inflation; the debt dilemma in Greece, whereby the attempted remedial measures have sparked public riots in the country, but non-action otherwise would likely lead to a debt default that could potentially cause a contagious financial crisis in the Euro region; rising inflation, especially in food prices that have increased incidences of poverty and seen as the root cause of social unrest in several countries; and the deceleration of US economic growth that would have implications for global growth and exports-driven economies in Asia.

Economists acknowledge there is still no light at the end of the tunnel yet despite the intense coordinated efforts by governments to deal with the problems.

In Malaysia, moderating growth in the near term and rising inflation have become inevitable facts. Being a highly open economy, Malaysia could still be affected by the spillover effects of global developments. And that should be reason enough for the Government to put its focus right, especially in terms of economic and risk management to ensure that the country’s economy and the welfare of its people are protected.

While most economists are optimistic that the Government’s Economic Transformation Programme (ETP) could continue providing momentum to the country’s economy and its subsidy programmes to minimise the effects of rising inflation, some are still concerned that the persistent political infighting could distract the Government from what’s more important and undermine its efforts to improve the country’s economy.

One economist says: “Global risks are rising, the country cannot afford to be apathetic and remain inward-looking. It’s high time that politicians from both divide come to their senses and work together to help the country remain on a sustainable path.”

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