As equities continue to rise, the risk of a correction always remains, and it is best to be prepared for any corrections and protect your portfolio. There are a few strategies that investors can use to protect their portfolio against market downturns, but first, investors need to be able to identify the stages of a market correction before deciding on what hedging strategy to implement. There are three stages of a market sell off:

• Stage 1: Market Top – This happens when markets stalls, there are signs of exhaustion and the market remains in overbought levels. It is important to note that this stage can last for an extended period of time. A good warning signal is when price makes a new higher high but momentum makes a lower high. This is known as divergence and is a sign of market weakness. During this stage, investors should look to incorporate option income strategies to collect premium and use strategies such as covered calls or call credit spreads. 
• Stage 2: Correction Starts – To help identify the beginning of a correction, 3 simple moving averages should be used (20D SMA, 50D SMA, 200D SMA). A quick successive move where price breaks below all 3 of these moving averages is an indication of a major correction and investors should now consider implementing a hedging strategy to protect their portfolio from further market downturn. 
• Stage 3: Capitulation, Market Bottom: After implementing a hedging strategy in Stage 2, the next step is to identify the market bottom. Volatility is an excellent metric for identifying possible market bottoms. This can be done using a volatility index like the VIX. Because volatility and equities have an inverse relationship, investors can look to the VIX to provide confirmation of market bottoms. After the VIX has spiked and starts to decline, but markets also continue to decline, it is a strong signal that supply has run out and markets are close to reaching the end of the sell-off.  

Portfolio Strategies in a Recession

There are three basic strategies investors can use to protect their portfolio once a correction has started. 

1. Perfect hedge – this requires converting all assets into cash, and to reinvest after the correction has taken place. 
2. Reallocate to defensive assets – investors can buy assets that have a lower correlation to equities such as fixed income (government bonds or investment grade), defensive equities with stable dividends (utilities, energy etc.), or commodities such as gold. 
3. Portfolio hedge – this involves buying a put option to protect the portfolio. This is usually a last resort as buying puts can be expensive and should only be done for protection against a correction greater than 5%. Investors should look to a portfolio hedge if they own stocks or ETF’s and do not wish to sell any holdings. 

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 a portfolio, investors should buy a put option on a broad-based index or ETF that closely correlates to the 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:

‍

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 using volatility as mentioned above. 

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. 

Expiration Date

Selecting an expiration date for hedging should be based on the magnitude of the correction. For smaller pullbacks (3-5%), shorter dated options (1-2 weeks) should be used to maximize Gamma, and shorter dated options are relatively cheap. For protection against larger corrections (5-10%), longer dated options (> 2 months)  provide better protection. This is because longer dated options are less affected by Theta (time-decay). 

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 and credit spreads when you are not bullish to offset costs of buying puts. 
• “OTM” puts provide catastrophic protection
• "ITM" puts provide better protection

‍