Hedging 101, An Educational Post

Hedging 101, An Educational Post
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Anyone Can Do It Once They Know How

by Alex King

When markets sell off, as they are doing at present, many investors - from large-account fund managers to the smallest individual accountholders - are caught unawares, freeze or react incorrectly, and promptly lose a lot of money.

There is a LOT of pain right now from a relatively modest selloff in markets since the middle of this month. Cope-posts on X are rising by the hour!

Now, since the dawn of time, if what you own is in essence the S&P500, the Nasdaq or the Dow Jones, patience has got you your money back. But only if you didn’t sell at the lows and then get brain fog as to when to buy back in, which is another trait common to all types of investor and trader. And if what you own isnt the major US indices then there’s a good chance that stocks or ETFs you own don’t have a track record of always making new all-time-highs if you just wait. So doing nothing isn’t always the best plan.

There are two headline methods of risk management to my mind.

1 - When market weakness hits, reduce exposure by moving to a heavy cash allocation in accounts. When markets firm up, redeploy this cash into long positions that have found support.

2 - When market weakness hits, hedge your long positions. If you can hedge perfectly, you achieve two things. Firstly, you suspend time. In a perfect hedge, if markets are selling off, the long side will fall but the short side will rise. For instance if you own $QQQ and $PSQ in equal measure, $QQQ will fall but $PSQ will rise. Net change to your account balance, zero. Secondly, you have the opportunity to actually make money from the selloff. As the profit accrues to, in this instance, $PSQ, you can sell $PSQ to cash that gain; then take the realized profit and use it to add to $QQQ at the lows.

Move To Cash

We all understand selling some positions and moving to cash - it’s a statement of the obvious. It’s hard to achieve but then everything in investing and trading is hard until you become skilled at it.

I truly believe anyone who is moderately numerate can be a skilled investor or trader, but most people prevent themselves from achieving this by over-thinking things, reading too much news, and having too many opinions about what “should” be happening in markets.

You can learn to spot local- and long-term highs and lows in markets and stocks by understanding stock charts. Yes, charts. Not p/e ratios, ARR, revenue growth rates, Fed policy, options Greeks or any other out-there strategy. Just a simple price and volume chart with a few pattern-recognition methods is all you need. Used correctly - and without emotion, this being key - you can learn to see tops approaching and to lighten up on securities ahead of time. You won’t get it right every time, you won’t call tops perfectly, you will make mistakes - but executed with even a modicum of skill, this method will keep you safer than sitting in the corner and hoping things get better (which is the dominant risk management strategy amongst more investors than you might think!).

We teach charts all day every day in our work. If you’d like free charts, follow us on StockTwits (here) where we post plenty each week, usually with commentary and “what if we’re wrong” analysis.

If you’d like our daily take on US equity indices - the S&P500, the Nasdaq, Dow and Russell 2000 - plus oil, bonds, volatility and key sector ETFs - sign up for one of the pay services on this site.

Hedge Your Positions

Hedging is one of those things that sounds very difficult and only for “hedge fund people”. It’s not as difficult as you think, but first you need to free your mind and set yourself up to do this.

A perfect hedge means that if you own an account containing $1 of stock A and $1 of stock B, then whatever happens in the market, the account balance will barely change. In my opinion, the existence of near-perfect hedges amongst index and sector ETFs means that it is well worth owning a goodly allocation of such ETFs (whether you’re running $10bn of other people’s money, or $10k of your own). It’s also I think worth owning the big index components - your Apples, Microsofts and so forth - because you can achieve an imperfect but still useful hedge with inverse index ETFs. It’s never true to say that if Apple goes up 1% an inverse Nasdaq ETF will fall 1%, but it’s often close enough to be useful.

Things that are hard to hedge are:

  • Esoteric stocks - microcaps, very high beta biotech or tech names, and so on - because by definition they don’t correspond well to the indices, and because using options to hedge them is often expensive and ineffective (because the stocks themselves are highly volatile and illiquid).
  • Short dated options, because by the time the market is on the move, trying to protect them with their opposite numbers will have already gotten expensive. Options markets move faster than equity markets, and with more brutality.

Things that are easy to hedge are:

  • Major index or sector ETFs
  • Highly liquid top index component stocks

To become skillful at hedging, you need to learn four things.

  • Stock charts, because only stock charts can tell you when bull is turning to bear and vice versa. Fundamentals can’t tell you this; Wall Street won’t tell you this.
  • Which instruments are useful hedges to the positions you own. If you own a lot of value names, consider inverse Dow ETFs like $DOG (here). If you own mainly S&P components, consider inverse S&P500 ETFs like $SH (here). And if you own a lot of Nasdaq components, consider inverse Nasdaq ETS like $PSQ (here).
  • When to buy the hedge - you won’t get this correct each time, you’ll miss the exact moment, that’s normal. In the same way that you might accumulate a long equity position slowly over time when markets have sold off, you might consider accumulating a hedge slowly over time when markets are raging.
  • When to sell the hedge - this is the most difficult part in my view, because if you get it right, you get free money. Meaning, you make money from the selloff when you sell the hedge at the lows. The profit that you made can be used to buy additional long positions at the lows. This is another form of compounding - one which is not well understood and not well used - but it can deliver wonderful results when used correctly.

Learn To Hedge With Cestrian.

So. Here’s what to do if you want to learn to hedge. Try our work. Hit the button below. Choose your service tier (Market Insight, RIA - Insight Pro, or Inner Circle). We provide a 7-day free trial on Market Insight; and you should know that RIA Insight Pro and Inner Circle will both have substantial price rises 1 August. Sign up in what remains of July to lock in our current low prices.

A final note. Our Inner Circle service provides real-time, real-money disclosure alerts when Cestrian staff personal accounts buy and sell hedges. And to quote some of our subscribers yesterday:

"First time, I'm making money from shorts. Love it!"

"I too made some money (and cashed gains) from being short for the first time today"

Over to you. Join us!

Alex King, CEO, Cestrian Capital Research, Inc

25 July 2024.