by Silicon Valley Blogger on 2010-02-19 14

Once youve opened an online broker account and consider yourself a stock investor, there are a few basic things youll need to think about when dealing with your investments: youll want to grow your portfolio but youll also want to protect any gains that you do make with that portfolio. If possible, youll also want to avoid experiencing any losses. Thats where the term hedging comes into the picture. When I was first starting out as an investor, I heard this term used all the time but didn’t exactly know what it meant. If I understood what it meant back then, I probably would have lost less money as a first time investor and beginning stock picker.

Hedging Your Stock Investments: Some Basics

The other day, I covered the topic of options trading and offered a simple explanation of how it works. This time around, Id like to discuss the more general topic of hedging a topic or investment principle under which options trading usually falls under.

So what does hedging entail? How about this analogy: the simplest way to think of it is that its a form of insurance. Hedging is simply insurance. If youd like to make sure that you protect your investments (and particularly your gains) to some degree, you can do so by applying a hedging strategy.

Money is money, no matter what currency.

While I’m thankful that I can insure just about anything from my home to my cat, as a young player in the stock market years ago, I became doubly excited when I discovered that I could also insure my portfolio. Even better, insurance for your investments comes free (unlike other forms of insurance out there).

There is far more to this than one article can tell you, but allow me to share with you one basic hedging strategy that Ive used successfully. Heres a real world example which Ive used: buy stocks or options in pairs. So how does it work?

When I feel that I can afford to take a little more risk with the money I have in my discount broker account, I dabble with leveraged ETF investing and buy one of the well-known leveraged etfs. One of my favorites is the Proshares Ultra Dow fund (DDM). This fund tracks and achieves 2x (twice) the performance of the Dow Jones Industrial Average. When the Dow goes up 1%, this stock goes up 2%. So as you can imagine, this is a very volatile asset and if you’re not careful, you can certainly stand to lose some major money.

When I buy this fund, I always hedge in order to insure my investment. For instance, if I buy 200 shares of DDM, I also buy 50 shares of ProShares UltraShort Dow30 (DXD). DXD does the same thing as DDM except it’s a short ETF, which means that when the Dow goes down 1%, DXD goes up 2%. So owning DXD has helped minimize losses in my portfolio.

Of course it also minimizes gains to some degree, but if my biggest problem is that I lost 25% of what I could have made, then that’s fine with me. I take my other 75% and invest it and make more. I believe that it’s better to make a little less rather than lose a little more.

You may also say that why dont I just own a stock index fund outright one that tracks the market exactly? Wouldnt it result in the same thing as purchasing DDM and DXD, which may tend to cancel each other out? The difference is that I can fine tune how much hedging I do in order to get results that I have a little more control over. With the combination of DDM and DXD that I purchase, I can control the amount of gains and losses I end up receiving, based on how my funds track the market.

Other Hedging Strategies

You may be interested to know that diversification strategies provide ways to hedge your portfolio as well. Weve written about using different asset classes to help with diversification before, and in particular, the products introduced in our EverBank review may be effective for this purpose. If youre open to investing in foreign currencies as a form of hedge, then check out:

• EverBank WorldCurrency Single CD a certificate of deposit that represents a single currency. EverBank has 17 individual foreign currency CDs that offer returns based on local currency rates.
• EverBank WorldCurrency Basket CD a certificate of deposit that represents a basket of currencies. This is what is called a multi-currency CD, and when you invest in it, your funds are diversified across 3 to 6 currencies depending on what type of WorldCurrency Index CD you purchase.
• World Currency Access Deposit Account this is a money market account that invests solely in foreign currencies. Youll need at least $2,500 to open an account, but it certainly provides a way to hedge by using foreign currencies (without having to get into Forex).
• EverBank MarketSafe CD this is another foreign currency CD offering, but it has no downside risk. Unfortunately, they have limited application times for buying in.
• EverBank MarketSafe BRIC CD this is a risk-free CD that invests in the BRIC currencies (Brazilian real, Russian ruble, Indian rupee and Chinese renminbi).

You can also hedge in other ways but they don’t always work. Gold has always been regarded as a safe haven for investors in down markets. You will often notice that when the stock market goes down, the price of gold tends to go up, which makes buying the shares of a gold ETF (such as GLD) pretty enticing. GLD may offer some protection here.

But (and theres a but!) the problem is that gold is a commodity and commodities aren’t always as reliable as we would like. Sometimes gold follows the market. So you may not want to put all of your hedging dollars into gold.

These are only a few examples of how hedging works. This is one of those subjects where reading a book about hedging may well be worth your time. Protecting your money is always worth it!

Here are a few articles you can read on the subject:

Contributing Writer: Tim Parker