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A Hedging Strategy Every Investor Should Know


Hedged portfolios have outperformed the broad-market indexes for the last 10 years. Here, how to master the art of constructing one.

First off, if you maintain a long-term investment outlook and you are a do-it-yourself investor, let me congratulate you. You have already won half the battle.

I spent 10 years in the online brokerage business, and the active-trader community is full of more drop-outs than success stories. It is not that you can't be a successful active trader, it is just difficult to maintain that approach for long periods of time -- and outperform the market while doing it. Believe me, successful active traders with track records greater than five years are by far the exception, not the rule.

But hey, being a buy & hold investor hasn't been a ton of fun either. The lost decade starting in 2000 has been the investment decade to forget. A portfolio that was long the market for the entire decade would have had negative returns. In other words, putting the money under your mattress would have yielded better returns!

So what is a conscientious long-term investor supposed to do? You can buy and hold… and hedge! What is hedging? If you have ever used the expression "hedge my bets," then you probably get the concept better than you think. Hedging, in investment parlance, is when you couple two investments that are counter-correlated. More simply put, when one investment rises in value, the other investment declines in value.

Hedged portfolios have outperformed the broad-market indexes for the last 10 years -- it isn't even close. And if you practiced a straightforward, disciplined hedge of the broad market for the last 10 years, you would have beat the market also (more on that later in this article).

But what good would a portfolio be if every time one investment went up $1, another investment went down $1? Well, that's the art of constructing the hedge. You need to construct your hedges with two thoughts in mind: (1) what investment idea/bias do I have? And (2) how "hedged" do I want to be to make money from that investment idea/bias? In other words, when one investment goes up $1, how much does the "other investment" decline by that is less than $1? When you construct your hedges, you need to construct them with these thoughts in mind.

In my experience, the best way to construct hedges with strong certainty of appropriate protection is to use options. The explosion of growth in options in the last 10 years is huge -- and the liquidity and availability has expanded considerably. Along with the explosion in ETFs and options on ETFs, you can really construct smart market exposure with hedges using options and ETFs.

Let's look at what I do with my portfolio. I want long-term exposure to the markets. I choose the S&P 500. I like to use the SPY -- the SPDR S&P 500 ETF. You buy 1,200 shares of SPY. Then, you want protection -- ie, the hedge that moves the opposite direction to the price of SPY.

To build my hedge, I do something you don't hear a lot about in the industry -- I build a time
ladder of protection using puts. By ladder, I mean that I own puts from every month there is an expiration between now and some future date -- adding up to the same number of shares that I own in SPY -- 1200 shares in this case. Each rung of the "ladder" is the month between now and the future date you choose.

Remember, I expect to stay long the market, so building a ladder that keeps expiring and needing to be replaced creates constant and balanced exposure and protection over time. Every month, some of my protective puts expire, and I either made a profit on them or they expired worthless. So, I buy new protection to build a new rung on the end of the ladder. Get it?

In my case, my ladder is roughly six months out. I look to buy protection six months out at about 10% downside for one-sixth of my SPY position -- ie, two contracts = 200 shares (1/6 x 1200 shares). I should always have six protective positions -- each one for each month between now and six months from now.

[Logistical note: You'll notice for the SPY right now, that no options exist for May or July yet. Typically, SPY always has the quarterly options for the next year + January (LEAPS) + the next three months expiration after this month. To still make this strategy work, you might need to roll to the five-month mark that you already own, knowing that once the four- or six-month mark comes available, you will adjust accordingly.]

This gives me balanced rolling protection -- since I am an investor that expects to stay long the market for the foreseeable future. However, this protection costs me: If I wanted to buy the June Put protection at about 10% downside protection today, it would cost me $2.30 per share -- or a little more than 4% annualized. That is the cost of hedging; it's like insurance -- it has a premium.

I look to offset the cost of my premium by selling some of my upside and reinvesting my dividends in to the protection. How do I do that? I sell the out-of-the-money cover calls on my position. And since time value evaporates fastest in the near month and selling a cover call is the same as selling time value, I sell the cover calls in the near month equal to 100% of my position.

For instance, January options expire this Friday. As I look for next month's new covered call to sell when January options expire, I look to sell my "excess upside" at roughly 6% above where SPY is trading right now. In other words, if SPY moves up more than 6% between now and next option expiration in February, I am giving up all of the upside in SPY above 6%. For this, I collect some premium that I get to keep.

Today, that premium is trading for about 1.2% annualized. Add the roughly 1.8% dividend from SPY to the mix, and I am collecting 3% to use to offset the 4% annual cost of the hedge. Net/net, my hedge is costing me about 1% annually -- but I am getting the exposure I want to be broad markets with downside protection, and I am sleeping much better at night as a result.

In addition, this strategy is fairly tax-efficient. You own the underlying SPY at all times, and ultimately this is where the tax man will eventually take his biggest bite. But if you aren't selling it and realizing profits, then you are putting off that tax bill. The options that keep expiring create tax events, but our put-protection losses offset the gains from the covered calls and the dividends. Fairly efficient, really!

For me, the 6% upside/10% downside approach works at a 1% cost. But every investor is different. If you are willing to sell more upside, you can get tighter protection -- or just pocket the premium. Or, you can take more risk to the downside, and then pocket the premiums -- or take more of the upside. Every investor needs to make these decisions for him or herself, but believe me, the optimal point to find on the risk/return curve is there for the taking. You just need to do the research and stay committed to the rolling structure of the trade.

Happy hedging!

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