At least as much as investors like making money in the stock market, they dislike losing money, and therefore many of us seek ways to hedge. We want the historically strong long-term upside of the stock market, but without all the potential downside. Few other popular investment classes can lose 20%, 30%, or even 40% in a year, but stocks can, and especially for those near or in retirement (or living on lower income), such a loss can be extremely consequential. However, how can you hedge without giving up a lot of upside in the process? And how can you sell short without facing large upside losses?
The straight-up strategy of buying put options to hedge or short (which is like paying a premium to buy insurance) can be effective and caps your risk, but it is extremely expensive to maintain, and most of the puts you buy will likely expire with less value than you paid, or no value. By simply buying puts, you should expect to spend at least roughly 5% of your portfolio’s whole value, annually, to somewhat effectively protect it.
Isn’t there a less costly way to protect a portfolio? One that still limits the risk of selling short? I thought you’d like to know some of the investment shorting techniques that we often consider.
Techniques to Short (or Hedge) While Limiting Cost and Risk
This interesting option strategy can be paired with any short, whether a company short or an index ETF. At the same time as shorting shares, you purchase call options to cap your risk at the call strike price (plus the cost of the calls). Specifically, you purchase call options expiring in three months or less that are at or very near-the-money (meaning the strike price is at, or close to, the share price of the short). Further, you purchase twice as many call options as the shares you’re shorting. So, if you short 500 shares of a stock, you purchase 10 calls representing 1,000 shares.
You do this because an at-the-money option always has a delta of around 0.5. That means its value will initially change by half as much as any move in the stock price. You purchase twice as many calls to in effect target a net cash delta of 1, and to then benefit from positive gamma—gamma being the rate of change in the option’s delta as the stock moves. If the short takes off, the doubled-up call options that you own can increase in value even more than the short stock rises, potentially resulting in total profits on the strategy even as the short soars. To be wrong on a short (or a market hedge) and still make money when it rises is obviously a nice outcome.
This strategy is particularly useful for stocks that may make dramatic moves—often speculative stocks that one also believes have significant downside, but that could instead run much higher. Of course, there is a downside to buying call options, let alone twice as many: This increases the total cost of your short, leading to a lower break-even price on the strategy. So, with this strategy, ideally the stock falls soon after you short it, so you can close it at your desired profit level, and also sell the calls for some residual value. Or, the stock simply falls so far that even though the calls you bought end up worthless, you’ve made your desired net return on the short. And once again, if the stock soars, you could also make money, and your risk is 100% capped. So, there are three ways to gain. Meanwhile, the clock is ticking since your calls typically expire in less than three months. If the stock goes nowhere, you lose the call value and need to reconsider the position.
Overall, buying calls on any short greatly limits the risk of that short, even though buying calls can also meaningfully add to the break-even price of the short. That’s even more true with this strategy, but setting up a delta neutral, gamma positive (DNGP) position could let you profit even if the short soars.
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Dialing the above strategy down by half, and often choosing a higher call strike price in the process, this strategy still meets the goal of containing the risk of a short, while reducing the cost of your protection compared to the above strategy.
In this case, if you short 500 shares of a stock at $30, for example, you could simultaneously buy 5 call options—covering the risk of all 500 shares—at a strike price of $35, expiring in six months. Let’s assume those calls cost $3 each, or 10% of the current share price. Your new short break-even price is $27, and your maximum risk is $35 (should the stock end expiration at $35 or higher). You still stand to profit handsomely should the stock fall to the mid-$20s or further, and you have peace of mind that your risk is capped.
In this realistic example, do note that your risk is still 29.6% upside from your net short price of $27. Shorting and buying calls to cap the risk is rarely inexpensive (10% in call premiums or more is possible), but it’s still worthwhile. An unprotected short that soars will often be much more expensive than the protection that you could have bought. And the peace of mind from the protection keeps your mind free to focus on other opportunities and decisions.
To get back to the strategy: When buying calls on a short stock, you often buy a few strikes out-of-the-money, expiring in several months to a few. An ideal outcome is the stock falls long before the call’s expiration, so you can close the short for a profit, and sell the calls for any remaining value. Should the stock rise soon after you short it, the long calls will offset some of the loss initially, and all of the loss above your strike price.
The advantages and disadvantages of this strategy are largely the same as the DNGP strategy above, except you’ll pay less for fewer calls options, and you don’t stand to make a net profit if the stock soars, as you could with the DNGP strategy. You’ll still have a net loss when buying just one call per 100 shares that you’re short and the stock rises, but the net loss will be contained. Finally, this strategy can be used for the longer term, too.
Since you always want to cap your risk on a short, a straight-up synthetic short with options won’t do. A synthetic short—selling a call and buying a put with the same expiration—equates to shorting the underlying stock or ETF, but has unlimited risk. To cap that risk, we can simply buy a higher strike call option at the same time. This has the arcane name above: A short three-legged box spread. This is a strategy to consider if aiming to hedge much, or all of, your portfolio exposure.
For example, with the S&P 500 at 4,400, if we want a short position on the S&P 500 expiring in a few months, and we’re using SPX options, we could sell a 4,700 call, use much of the proceeds to buy a 4,100 put, and then spend just a bit more to buy a 4,900 call as well. If the market falls, the puts we bought offer full protection beneath our strike (minus the small debit you paid for this spread). If the market soars, the most this short will cost is the 200 point spread between your two calls (plus any debit you paid at the start). That 200-point spread is a 4.26% move—an absorbable risk for a typical index hedge.
Buying the call to cap your risk is peace of mind against big upside surprises in the market. Importantly, this protection also makes it feasible to set up these positions for the very long term—a year or longer—to gain the benefit of a long-term hedge with capped risk. Since the market can fall at any point over a long period, you want protection in place for any time. And you want protection against large declines, not necessarily run-of-the-mill 5% declines (those don’t make much difference, and are unfavorable to protect against with options). A long-term spread such as this on an index is possible and feasible for years knowing your risk is limited even if the market goes on a long march higher. That said, if the market does rise well beyond your put strike, you’ll want to reassess your position, because the protection it offers has waned. You’ll likely need to close and set up a new spread at higher price levels.
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Finally today, the risk reversal strategy. This is another way to short a stock or index while capping your risk with options, and it also defines where you’re ready to take your profit.
Let’s assume you short a stock at $50. At the same time, you sell-to-open an equal number of puts striking at $35, and use the proceeds from the puts to buy an equal number of calls at $65, with the same expiration date. So, you’re short a stock at $50, you’re short its puts at $35 (that represents an obligation to buy the shares at $35 if they fall lower—you’d be buying to cover your short shares), and you own protective calls at $65.
The options that make up the risk reversal strategy are usually set up at little to no net cost (or even a credit), so you have that advantage. Now, if the stock falls below $35, your short puts will be exercised at expiration, covering your short stock at $35. You’ve made your desired 30% return as the stock fell from $50.
Conversely, if the stock rises above $65, your risk is capped at that level (a 30% loss), and you can choose to close the whole position or just sell the long calls at expiration and keep the short going (setting up new protection). A risk reversal is a low- or no-cost way to define your risk and your potential return on a short. Its main disadvantage is that it’s most beneficial right near expiration, and not long before it. If the stock falls sharply right away, you may want to take the gain in your short, but the short puts could still carry a lot of costly time value, so you’d rather wait on the whole position before closing those puts—potentially tying your hands for a long time. Hopefully, the short doesn’t rise again while you wait.
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Naturally, you only want to use these instruments and techniques if you believe they may offer attractive trading and investment opportunities in the prevailing market conditions, so you should not assume that these techniques can be reasonably, or should be, employed at all times. Similarly, in implementing the Fund’s investment program, we may utilize other hedging or financing techniques we deem advisable.
In Conclusion
The purpose of hedging is to have assets in your portfolio that move the opposite direction of other assets, preferably at a delta as close to -1 as possible, so they offset each other, and better preserve your total asset value. You can aim to hedge an entire stock portfolio, or portions of it, or specific positions, guided in part by the volatility of your holdings compared to the market, and the strategies you’re using to hedge.
Selling a stock short to profit on it falling is a different strategy from straight hedging (or shorting) of market indexes, but one that is also best done with protection against growing losses. The strategies outlined today work well to protect both broad market hedges (typically using options on the indexes or the index ETFs), and individual company shorts. One never knows when the market will make a dramatic move. Shorts and hedges can help against shocks. But you also need to protect against dramatic moves higher, making sure the risks of your shorts and hedges are contained.
Initially, moving to protect existing shorts and hedges adds costs, and could actually lead to additional losses if, for instance, the market then just bounces around. But over the long term, over multiple market cycles, mitigating the risk on any counter-market investment should, in our view, pay for itself (through contained losses and peace of mind to focus on other ideas), while still letting the investor potentially benefit from shorts or hedges when they fall. And isn’t that the point?
—Jeff Fischer, Chief Investment Officer