Here is the general idea – since the market (i.e. SPY) is such a huge determining factor in how your trades will perform, then having a portfolio that is heavily biased in one direction is subject to serious damage if the market goes counter to that bias.
In other words, if you were Long ABBV, PFE, MSFT, and TSLA – and even if all four of them are strong against SPY, you would be pretty screwed if the market tanked overnight.
Sometimes this isn’t much of a concern – the market has periods of stability, and while anything can happen, you can be fairly confident during those periods, that there won’t be any significant swings in SPY. And even if the market was to go down the next day, your stocks should be strong enough to weather the storm until SPY bounces back.
I am not going to go too much into the notion of “reducing your exposure” except to say that you should use your common sense. If you are loaded up with all bullish positions and 100% of your account is tied up into those positions….that is not a very safe thing to do. However, I caution about going down the other road as well – one could have easily spent the entire past year worried about carrying any positions at all. And guess what? The market continued to go up. Yes, there were some dips, but they were all temporary. Being too cautious is not a great model for producing income either. So just don’t be a total idiot in this regard, and you should be fine.
Hedges are for when SPY is more volatile. The last two days were an excellent example – at the end of yesterday (12/15) one would have been bullish, and rightfully so. But there was also the possibility of a pullback, or even reversal. So yes, you can sit on the sidelines during that time. However, you’ll pretty much be sitting there watching the rest of us play.
Hedges allow you carry positions into a somewhat volatile market. There are different types of Hedges:
Overall Hedge – this is your no bullshit, straight up hedge. SPY puts, Short S&P futures, VXX calls, etc. If your portfolio is bullish (if it is bearish just reverse everything), you can just hedge against the market. If the market goes down, so do your positions (most likely), but these hedges will go up. I prefer VXX calls when using this type of hedge. The beginning of December is an example of where SPY dropped 3% but VXX went up 43%. An even better example of this would be the VXX calls I took last night – I bought them around 5-10 minutes before the market closed and sold them this morning for a 18% profit. If I would have bought SPY puts instead, at the exact same time, and sold them today also at the exact same time, my profit would have been only 6%. VXX calls were 300% more effective than SPY Puts.
Individual Position Hedge – there are various ways you can use options to hedge your individual positions:
– If you were holding ROKU 215 calls that expired this Friday, worth $7, and you are worried (rightfully) that ROKU might open in the red tomorrow, you could sell the 225 calls against them for $2.30. If ROKU dropped, you would collect that premium. However, this caps your potential earnings at $225.
– If you were holding 500 shares of PFE you could sell the 63 calls against them for .35, as a covered call, giving you some downside protection, but once again capping your upside on the stock.
Balancing Hedge – your portfolio is bullish, so you can add some bearish positions to it. Using Relatively Weak stocks allow you to potentially be in profit in all your positions. For example, UPST has been Relatively Weak and has a bearish daily chart – so if you were to buy UPST Puts, there is a chance even if the market were to open strong tomorrow, UPST would still be in the red. However, if the market opened down, UPST would be really in the red.
Now comes the question of How Much do you hedge? And the answer is…..up to you! Seriously, it is up to you. How concerned are you?
If you had $5,000 worth of bullish positions, perhaps some calls on ABBV and PFE worth $2,500, and a Call Debit Spread on AMGN worth $1,000, and then throw in some stock with $1,500 worth of CAG.
Now are you risking $5,000? No…there is no real scenario where those calls with be worthless and the stock goes to zero. But if SPY dropped $4 in the morning, it is reasonable to assume that you might be in danger of losing around $2,000. A perfect hedge would protect the entire $5K, which you don’t need – you just want to mitigate against potentially losing $2,000.
So let’s look at VXX calls – the at-the-money 21 strike calls go for about .70 cents (or $70). Today for example, SPY was down .88% and VXX was up 4.21%. So if SPY dropped $4, VXX would most likely go up $1. What would happen to those VXX calls? You would get roughly a $90 gain per call (increase in volatility is going to impact you VXX pricing as well). If you got 10 calls for $700, you would protect roughly 1/2 your potential losses.
But what happens if SPY opens higher, do you lose the $700? No – your worst case scenario on these would be too lose half the hedge – or $350.
That is the type of calculation you can do for any hedge. Like with the PFE covered calls – You are protecting 35 cents of your $61.07 stock. If PFE opened down $1 tomorrow, that call would drop to roughly 17 cents, meaning you mitigated against 18% of the drop. But if PFE opened up $1 tomorrow, you would be giving up a lot more than 18% of the upside.
Overall – hedges are a matter of personal preference and risk tolerance. I tend to carry swing trades often, and I will generally balance my portfolio accordingly. I have found that stocks like TSLA make great counter-hedges – if I have a lot of bullish position, and TSLA was relatively weak to SPY, then it doesn’t take many TSLA puts to act as a significant enough hedge. Using Relative Strength and Relative Weakness gives you an additional edge and allows for the potential of being profitable in both your hedge and your original positions.
If you are a new trader it is also best to make sure your position sizes are small, and that you are never carrying too much risk. However, at some point you may find yourself swinging a large number of positions, and hedges can be an essential way to stave off any significant loss.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.