Hedging Stock Portfolios
I've received numerous requests on Twitter and Facebook for the details on how I hedge my stock portfolios. Rather than respond to each request, I thought I'd just add a page to the website and discuss my hedging strategies based on the questions that traders have sent.
Why do you hedge?
I hedge to drastically reduce the risk of loss to my portfolios from a potential 50% or move down in the stock market. Hedging is not designed to increase my returns. It is meant to preserve the value of my portfolios. The benefits? Preservation of capital in my retirement accounts and peace of mind knowing that I have less risk than the general market. I must protect my “Mr. Serenity” moniker!
For what kind of risks do you hedge?
I hedge my stock and
ETF portfolios for the market risk associated with owning a long stock
portfolio during severe down moves of the market.
When do you hedge for a market downturn?
I used Keltner Bands for years to tell me when to put the hedges in place and when to take them off. These bands adjust dynamically to changing market direction and volatility. They are offset from an exponential moving average. (The bands get wider around the EMA during periods of more volatility and narrower with less volatility.
While that got the job done for years, I decided to investigate ways of reducing the cost of hedging and attempt to do fewer hedge trades. I also wanted to offset some of the disadvantages of Keltner Bands when in lower volatility periods by combining Keltner Bands with Bollinger Bands and Donchian Channels . My target is to use the first of the three indicators that signals a change in direction to the downside and put on my hedges. When the direction turns to DOWN, I fully hedge the portfolio. When the first indicator turns up, I take the hedges off and take on stock market exposure and risk. I did my research study live on a TrendSpider webinar on Sunday night, November 17th, 2019. You can see a recording of the presentation if you want to see the logic we went through to get to our final new and improved hedging strategy.
Note: I never move the stops away from the market, only in the direction of the trend, so when the bands turn against the trade, stops are held in place until executed or they start again moving in the trade's direction.
Why/How did you select 50 days for your period to get into a hedge and 21 days as your time period for getting out of the hedges?
I am a retired guy these days and don't want to do any more trades than necessary. A month of business days, subtracting weekends and holidays, is around 21 days, depending on the month. I usually don't concern myself with movements inside a month, so I settled in on 21 days for my most of my indicators. I wanted a bit less active signal to get into the hedge trades, so I would have less trades and give stocks more room in volatile markets to move. I wanted something beyond a month and settled on 50 days for my indicators on the downside signal. I decided to stay with 21 days to get out of the hedges. I used these time periods for all the indicators and the Average True Range calculations. You can and should always set these numbers anywhere that suits your situation.
How do you hedge for a market downturn?
In my taxable accounts, I short the SPY exchange traded fund. In my IRAs, I use a triple leveraged, inverse etf like SPXU. These are liquid vehicles and my positions represent a downside bet on the market measured by the S&P 500 Index. You should look at your own portfolio and what risks you wish to hedge against and use any one of numerous indexes that can be your trading vehicle. You certainly don’t need to use SPY’s like I do.
How do you size your hedge position ?
I hedge the volatility of my entire portfolio by using a simple spreadsheet. First, I calculate the ATR if my entire portfolio over the last 21 days to give me a measure of the portfolio's volatility. Next, I do the same thing for the SPY etf. I then calculate how many shares of SPYs would it take to equal my portfolio's volatility and that's how many shares I use for a full hedge. I've included the calculation in a worksheet in the ETR Trading Tools for Excel , available for purchase at the ETR Store .
This assumes that my long stock portfolio value will tend to decline in a DOWN TREND and the SPY hedge will increase in value a similar amount. Therefore, the portfolio is volatility hedged. It never is a perfect hedge, but usually is in the ballpark.
This is what I do for my portfolio. I describe it all here to help traders new to the concept improve the way they trade their own portfolio. I am not suggesting that this is the way you should hedge or even that you should use hedging at all. There are a lot of other ways to hedge and manage your portfolio. Be creative, keep it simple and enjoy the ride!