Top Hedging Strategies to Safeguard Your Investments from Market Volatility
Effective hedging strategies can reduce market risk depending on the asset or portfolio of assets being hedged. Some of the popular hedging strategies are portfolio construction, options, and volatility indicators. Let us delve into these strategies in detail.
Modern Portfolio Theory
Modern portfolio theory finds an efficient frontier of risk for an amount of expected return using statistical measures. Optimal portfolios are created as the theory relates to the correlation between various assets and the volatility of assets.
Many financial institutions have used MPT in their risk management practices. The efficient frontier is a curved linear relationship between risk and return. Investors will have different risk tolerances, and MPT can help to choose a portfolio for that particular investor.
Options
Options are a very effective tool. Investors can often buy put options to hedge an individual stock with reasonable liquidity against the risk of a downside move in protection. Puts gain value as the price of the underlying security goes down.
One of the major drawbacks to this strategy is the amount of premium that needs to be bought into the put options. Purchased options are susceptible to time decay and lose value as they move toward expiration.
As mentioned, vertical put spreads may reduce premium amounts spent, but they also limit the amount of protection. In this case, this strategy only protects one stock, and a diversified investor cannot afford to hedge each position.
Investors use index options to hedge a larger, more diversified portfolio of stocks. Index options are related to the larger stock market indexes, such as the S&P 500 and Nasdaq. These broad-based indexes include a variety of sectors and provide a good measure of the overall economy. Stocks tend to be correlated, in general, they tend to move in the same direction, particularly during times of higher volatility.
Investors can also hedge by putting options on the indexes in order to minimize their risks. Some of the possible strategies that can be used to minimize risks include the use of bear put spreads. Although this protection still costs the investor money, index put options protect a larger number of sectors and companies.
Volatility Index Indicator
The other hedge is through the use of the volatility index (VIX) indicator. The VIX measures the implied volatility of at-the-money calls and puts on the S&P 500 index. It is often termed the fear gauge as the VIX increases with volatility.
In general, any reading below 20 implies low volatility, while any reading below 30 is quite volatile. There are now exchange-traded funds that track the VIX. Investors can use the ETF shares or options to go long on the VIX as a volatility-specific hedge. Of course, while these tools are certainly powerful, they can’t reduce all market risk.
What is Hedging in Finance?
Hedging is a financial term for investments that pay off if the principal investment thesis is wrong, thereby limiting the investor’s exposure to risk and expected losses. An effective hedging strategy may limit the investor’s maximum possible payoffs, but it also limits their maximum losses.
How Are Hedge Funds Different From Other Investors?
A hedge fund is a private investment fund managed by professional portfolio managers. Since it is accessible only to high-net-worth investors, a hedge fund can employ alternative investments and strategies that deliver higher returns than the market.
What Hedging Strategies Are Available for Retail Investors?
Even though sophisticated hedging strategies might be not feasible for an individual, there are ways in which a retail investor can minimize their risk exposure. For example, one of the most straightforward applications is the three-fund portfolio that holds a stake in domestic equities, international equities, and domestic fixed-income instruments.
You can be pretty sure that a market downturn will not correlate equally with all three classes of assets; thus, this type of portfolio ensures at least some of your investments should end up being stable.
Lastly, investors can take an active management approach, for example, by selecting particular firms to invest in, firms that are most likely to succeed during a recession, or buying options that pay according to results if their main investment goes wrong.
Conclusion
Investors minimize the risk of their investments by using hedging strategies. Among the best strategies for minimizing the downside risk with a good balance are diversification, an options strategy, and correlation analysis.
The most effective hedging strategies reduce the investors’ risk while allowing them to be exposed to the market without harming the opportunity to make a profit.
