What is a portfolio hedge?

A portfolio hedge acts as an insurance policy and is used to protect your portfolio during a market correction. If the market makes a turn for the worse, a portfolio hedge will cover some of the losses made in your stock portfolio. To perform a hedge on your portfolio, buy a put option on a broad-based index or ETF that closely correlates to your portfolio. The put option will become profitable when the market moves lower and this offsets the losses from the portfolio - an imperfect partial hedge. The downside to this method is that it becomes expensive if the investor is constantly buying puts anticipating that a market correction could happen at any time. Therefore, this method does involve active management and timing to minimize the cost of the hedging and maximize its effectiveness. The diagram below shows how buying a put option provides a portfolio hedge:

While the above is an example of an imperfect hedge, a perfect hedge also exists. A perfect hedge requires the investor to convert all holdings to cash and reinvest after correction. This is very cost effective as the investor is protected against a market correction while only having to pay the commissions for selling and later buying back their shares.

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Who should use a Portfolio Hedge?

A portfolio hedge is used in the case where the investor holds a portfolio of stocks/ETF's and does not want to sell any holdings (for dividend income). 

Efficient Hedging Strategy

There are two main factors when considering a hedging strategy using put options - timing, and the hedging instrument. 

Timing

The best time to buy a put for your portfolio us during the market correction. While this may sound counter-intuitive, by buying puts too early before the correction, the investor will lose a significant portion of the portfolio to pay for the market correction that has not yet happened. By buying a put during the correction, the initial cost may be higher, but it does minimize the cost of buying puts while waiting for the correction to take place. The exit strategy for buying puts is to simply wait for the correction to be over. One way of doing this is to check when the volatility peaks. Historically, volatility indices tend to peak during market bottoms. By looking at the volatility index associated to the index that correlates to your portfolio, the investor can make an accurate estimation of the market bottom.

Hedging Instrument

Picking a hedging instrument that has a high correlation with your portfolio is the best way to perform a portfolio hedge. For a portfolio that has a balanced composition of all Canadian sectors, buying puts on the XIU ETF will provide a good hedge for the portfolio. When a portfolio has a higher concentration on a specific sector or industry, picking an index that tracks that specific sector will provide better results. For example, portfolios that are concentrated in a specific sector or industry such as Financials would be better protected by the XFN ETF that tracks Canadian financial companies.

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Contracts Needed to Hedge a Portfolio

This depends on the size of the portfolio and is calculated using the following formula:

Best Practices

Expiration Date

When choosing an expiration date for hedging purposes, a longer dated put option works best (> 2 months). This is because longer dated options are less affected by Theta (time-decay). While even longer dated options could work, they are usually more expensive, have lower liquidity, and provide protection for longer than what is needed as most corrections happen over a short time period.

Strike Price

Strike prices for hedging purposes can be grouped into 2 categories:

• Catastrophic - Major downside correctionsome text
  • Buy out-of-the-money Puts: 30-40 Delta
  • Cost roughly 1-3% of portfolio value
• Comprehensive - Any downside correctionsome text
  • Buy in-the-money Puts: 50-60 Delta
  • Cost roughly 3-5% of portfolio value

Hedging Tips:

Constant hedging is not cost effective:

• Better late than early
• Sell covered calls to offset hedging costs
• Index options provide cost efficiencies
• "ITM" puts provide better protection

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