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 traders have sent.
Why do you hedge?
I hedge to drastically reduce the risk of loss to my portfolios from a potential 50% of more down 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.
For what kind of risks do you hedge?
I hedge my stock 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 use the relationship between prices and Keltner Bands 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 (EMA shown as a dotted white line in adjacent chart). The bands get wider around the EMA during periods of more volatility and narrower with less volatility.
I use two sets of Keltner Bands, both of which use the Average True Range (ATR) period of 20 days. My "fast moving bands" use 1.5 times the ATR in distance from the EMA and the "slower bands" use 2.5 times the ATR in distance from the EMA. You can see on the chart to the left how these red and green lines usually are on either side of the price action.
When price action goes through a red line on the bottom, one-half of the portfolio is hedged. When price action goes through a green line on top of the price action, I take one half of the hedges off. When both of red lines are pierced to the downside the TREND IS DOWN. When both of the green lines are pierced to the upside, the TREND IS UP.
How did you select 20 days as your time period for the EMA and ATR?
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 20 days, depending on the month. I usually don't concern myself with movements inside a month, so I settled in on 20 days for my portfolios. You can 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 in the way I use them represent a downside bet on the market measured by the S&P 500 Index.
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 20 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. The half hedge would be half that amount. 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. However, there are a lot of other ways to hedge. Be creative, keep it simple and enjoy the ride!