How to Hedge Long Stock Positions

I remember a time when investing meant buying quality mutual funds, stocks, and fixed-income investments from a full (overpaid) service broker, ), sitting back, and allowing the theory of “buy and hold” to run its course. With this routine came a confidence that, over time, stocks would realize a return that would satisfy all patient investors. But then again, I also remember a time when everyone left their front doors unlocked. Society unfortunately is not as secure, and Investing isn’t that simple anymore. Now successful investors need to construct their investment portfolios to guard against a market disaster. Successful traders hedge the risks associated with a long-only portfolio.

Hedging stock investment(s) against catastrophic loss can take several forms. Long stock traders often have used stop-loss and stop-limit orders to close a long stock position if that share price falls to a pre-determined level. Many traders use a 10% lower bound to place their stop-loss price. This allows the trader to believe that the most he will lose on this particular investment is 10%. The problem with this strategy is twofold. With a stop-loss order, if the stop price is breached, a market order is generated. This guarantees a fill but the price is unknown.

For example, if XYZ stock was trading at $50 and were to gap lower by 50% one morning, the $45 stop would be elected, generating the market order to sell, only the market price for this stock is now trading around $25, and that is the price at which this order would be filled, closing for a loss of 50%! Using a stop-limit order has similar issues. However, with the stock trading at $25, traders would be working a closing sell order WAY above the market at $45 and would not be able to sell the losing position. The other issue with using stop orders (as I hear from traders) is that it seems that often the market whips around, stopping out potentially winning trades before they have a chance to become profitable. During periods of high volatility, this can become the norm. Therefore consider reducing the size of the trade by 50% and widening the stop loss to perhaps 15%.

Options can provide a more dynamic hedge. Long stock can be hedged against a price decline by purchasing a put option at a strike price 10% below the current level. The put gives the owner the right (but not the obligation) to sell the stock at the strike price. The risk to a long put in the premium paid for the option. By owning the “married put,” the long stock holder can rest easy that regardless of where the stock price goes, he is hedged, for the life of the put. All options, put options included, are referred to as wasting assets, meaning that as time passes, the value decreases. After expiration, the long put expires and the downside hedge is gone. In order to remain hedged, another put would have to be purchased. Over time, continuing to purchase put premium could severely cut into any stock profitability. The advantage to the married put strategy is the hedge is dynamic. What I mean here is even if the stock gaps lower, a put hedge will theoretically increase as the stock falls. As long as the put is active, the investor can rest easy that he has hedged any downside loss to the difference between the strike and the current stock price.

A trader can also use a collar trade to offset the vega exposure and the time decay of a straight put purchase. A collar is a three-way spread that includes long stock, a long married put, and an overwritten call. For example, XYZ stock, again trading $50; you could purchase a 43-strike put and simultaneously sell the 55-strike call, often for zero (or minimal) premium outlay. You are using the proceeds from the call sale to finance the purchase premium on the put. Remember, however, nothing comes free in options. By selling that call, you are capping your upside profitability to the difference between current stock price and the short strike. Again, the long put will provide a downside dynamic hedge to the long stock position, but with the collar, the zero cost means if the stock doesn’t move higher or lower, the premium decay will not cut into your returns.

The last way to have a hedged position in a long stock position is actually not to have a long stock position at all! The stock-replacement strategy is typically one in which you buy an in-the-money call as a replacement for long stock. Long calls give the right to purchase the stock at the strike price between now and expiration for the premium paid. The maximum risk to a long call is 100% of the premium paid. Therefore that maximum risk is ABSOLUTELY the stop loss when entering into the position. While the option is active until expiration, the long call gives upside exposure to stock price moves. An options value is made up of intrinsic value and time value. Buying an in-the-money option can decrease the amount of time value that will disappear as the option approaches expiration. For example, we’ll again look at XYZ, priced at $50. Buying the 47.5-strike call for $5 will limit your risk to that $5 premium (10% of the stock price). That is the most you can lose. The risk to long stock is unlimited down to zero, so $50 dollars in this example. The potential gains are unlimited (just like long stock), should the stock rise above the strike plus the premium paid. The strategy will be profitable if the shares rally above the upside breakeven of 52.5 at expiration. And as always, just like long stock, should the shares rally before expiration, the long call can be sold in the open market to realize any potential profit.

Hedging long stock positions is becoming increasingly important especially in light of the market’s disastrous 2008 plunge. Buy and hold has not worked in the past decade as the overall market has a negative performance over that span as well. In this volatile trading environment, hedging your positions can preserve your trading capital and allow you to get a good night’s sleep.

Photo Credit: deltaMike

Share and Enjoy: