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Hedging Your Investment Portfolio

September 24, 2014

 

For many, hedging conjures up thoughts of landscaping on a hot summer day. However when it comes to investing, hedging has a completely different meaning. Hedging is a strategy that is not only beneficial, but some may argue essential, as a means of protecting your investment portfolio.

 

While the stock market has enjoyed tremendous gains over the past several years, it is easy to forget how quickly and dramatically the market "blew up" a few years ago. The S&P 500 Index declined 53% from October 7, 2007 to March 9, 2009 and there was no shortage of pain. Even if we do not experience another market-meltdown like we all witnessed during the “Great Recession of 2008,” it is normal and actually healthy to experience a 10%-15% correction in the equities market, which may create new buying opportunities.

 

Equity and index options may be utilized as tools of risk management acting as insurance policies to protect your equity holdings against a decline in market prices. Similar to paying an insurance premium for your home and car to “hedge” against a catastrophic loss, investors can also protect many of their stocks, exchange traded funds, (ETF’s), and even an entire investment portfolio by utilizing a strategy known as “protective puts.” This type of option strategy is known as a hedging, and many smart institutional money managers have been utilizing this technique for years.

 

If you are concerned that your stock's, ETF's, or overall trend of the market is headed lower, you can purchase a protective put on thousands of individual stocks and ETF's, and this will give you the right to sell at a certain price at aspecific time in the future. This gives the investor the right to sell at a specified price, no matter how far the stock, ETF, or index fund, has declined in value.

 

What is particularly appealing about the protective put strategy is that you are not limiting the upside growth potential of your underlying stock, ETF, or index fund and while maintaining peace of mind of downside protection should the market decline. If you are inclined to believe the markets are poised for a decline, purchasing a putoption may be more advantageous than selling short or exiting the position outright. Utilizing a stop loss can also be frustrating. Too often you may be “stopped out” of your position just to watch it reverse itself to higher levels after already being closed out of the position.

 

If you buy shares of the underlying stock or ETF at the same time that you purchase a put, this strategy is known as a married put. If you purchase a put on a position that you have held for some time, the strategy is known as aprotective put. Both of these hedging strategies combine the benefits of stock ownership, which includes - dividends and a shareholder’s vote, with downside protection that a put provides and let's not forget "peace of mind, particularly in a volatile market.

 

While equity options may help you mitigate risk, it is important to remember that all investments carry some degree of risk and are never guaranteed. Options are not suitable for all investors. Please contact us and we will send you a free copy of the risk disclosure document Characteristics and Risks of Standardized Options that will provide you with the information that you need to know.

 

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