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February 23, 2013

The hedge preserves the edge.

If you hedge too much, you naturally dull the edge, so the challenge is to find a delicate equilibrium: How much risk are you willing to absorb in pursuit of a specific level of returns?

IN ADDITION, THE RELEASE of minutes from the Federal Reserve’s policy-setting committee, indicating that the central bank is debating an early end to its easy-money policies, spooked some investors and sent the CBOE Volatility Index—the VIX, or market-fear gauge—surging higher in anticipation of a stock-market correction.

Michael Schwartz, Oppenheimer & Co.’s chief options strategist, says that his clients’ top question is: How many puts should be bought to hedge my portfolio?

Our recommended hedge, courtesy of Belmont Capital’s Stephen Solaka, was to buy 32 SPDR S&P 500 ETF Trust March 150 puts and sell 32 March 145 puts when the exchange-traded fund hit $152. The hedge still works. SPY is at 1500, a major market support level, so any declines below that could cause the hedge’s value to surge.

Last week’s column also prompted readers to send me their own hedges for review. While I don’t give private investment advice, sharing tricks of the trade is another matter.

www.cboe.com/Strategies/IndexOptions/BuyIndexPutstoHedge/part7.aspx .

The formula may lead you to believe hedging is somewhat scientific. It is not. Hedging is an art.

Few investors ever hedge their portfolios against a complete loss of value. A total hedge is usually too expensive, and besides the chance that stocks will drop to zero is—knock on wood—very low. So investors generally try to determine how much pain they’d be willing to suffer if the market were to tank. Two related questions to ask yourself: Do you indeed expect the stock market to slide? And, if you do: When do you think the decline will occur?

The March 1 sequestration deadline, when $1 trillion might be cut from the federal government’s budget, is a potential event against which many people are starting to hedge. And when you hedge, think about packing as many market-moving events as possible into the expiration.

Some investors buy tactical, three-month hedges because they are less expensive than hedges for an entire year and capture short-term market-moving economic reports. Sometimes, they’re even long enough to cover an entire corporate earnings season.

ANOTHER POINT IS SOMEWHAT obvious, but nonetheless trips up many investors: Hedge your portfolio against its benchmark. If your holdings are large-capitalization issues, use the Standard & Poor’s 500’s options, or SPDR S&P 500 ETF puts, which track the benchmark index. Don’t hedge with a small-cap stock index.

How urgent is it to consider hedging? With the VIX around 15, hedging is relatively inexpensive. But that will quickly change should Congress do nothing to address the sequestration deadline.