In this post we will go into the various strategies available to us when hedging our portfolios to offset risk and reduce losses.
Hedging Strategies
“Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”
- Warren Buffet
When investing it can be easy to get caught up in short term profits and strategies that reflect that. In the long run though, making money is much more about preventing losses than it is winning in the short term. To help us accomplish that, we look into the concept of hedging or the use of financial instruments to offset risk and potential losses.
ETFs using Options
TAIL
Buys puts on the S&P 500 for downside protection. Puts guarantee the right to sell stock at a certain strike price and therefore profit from drops in the underlying stock price. If S&P 500 drops, the puts will gain in value and provide a profit for TAIL.
HIBS
Provides -3X exposure to 100 highest beta stocks in S&P 500. Beta measures the relative ratio of movement between as asset and the overall market with values larger than 1 moving more than the overall market and values less than 1 moving less than the overall market. If the S&P 500 drops, the high-beta stocks will drop more yielding a larger return for -3X leveraged HIBS.
ETFs tracking VIX futures
VXX
This ETN buys short term futures contracts on the VIX to provide downside protection. Unlike an ETF, an ETN doesn’t hold assets but instead is backed by unsecured debt of the note issuer resulting in more risk but better tracking of the underlying index. If the S&P 500 drops, volatility spikes can result in large profits for VXX.
VIXY
This ETF buys short term futures contracts on the VIX to provide downside protection. Unlike VIXY which is an ETF, an ETN doesn’t hold assets but instead is backed by unsecured debt of the note issuer resulting in more risk but better tracking of the underlying index. If the S&P 500 drops, volatility spikes can result in large profits for VXX.
SVXY
This inverse ETF shorts the short term VIX futures contracts to provide negative exposure to volatility. This means that If the S&P 500 drops, volatility tends to rise allowing the VIX futures to rise resulting in losses for SVXY. When the market rises or stays relatively constant, volatility will tend to drop in turn yielding profits for the short SVXY.
ETFs using VIX options/futures
PHDG
Buys S&P 500 equities while providing downside protection through use of VIX futures. VIX is the CBOE volatility index and tends to spike when the overall market drops. If the S&P 500 drops, volatility tends to rise allowing the VIX futures to rise faster than S&P 500 drops to provide profit for PHDG.
XVZ
This ETN buys short term and mid term futures contracts on the VIX at different ratios to provide profit from volatility and reduce decay. The ratios at which the short and mid term contracts are held depend on the slope of the VIX futures chart and can be updated daily as conditions change. If the S&P 500 drops, volatility spikes can result in large profits for XVZ.
VXZ
This ETN buys mid term futures contracts on the VIX with 4-7 months to expiration to provide profit from volatility. The longer term contracts reduces VIX correlation while reducing decay over time. If the S&P 500 drops, volatility spikes can result in large profits for VXZ.
VIXM
This ETF buys monthly futures contracts on the VIX with weighted average of 5 months to expiration to provide profit from volatility. The longer term weighted average expiration of the contracts reduces VIX correlation while reducing decay over time. If the S&P 500 drops, volatility spikes can result in large profits for VIXM.
Conclusion
Options are not the only way to hedge your portfolio as one can see with the info provided here. These alternatives to straight long puts on the market indices provide means to hedge against risk and potential losses without the need to take expiration dates etc into account. These hedges should generally be applied sparingly to provide short term protection. Some of the strategies employed though do provide a longer term outlook to reduce the effects of decay from holding these positions for extended periods of time.
