The stock market is in decline right now, and at moments like these, individual investors tend to make mistakes…
They make the mistake of either being in the market or being out of it.
Too bullish or too bearish… too extreme and too absolute.
You absolutely should hedge your investments in times like these, in one way or another.
But there is one thing you should never do: Don’t overhedge.
In today’s article, I’ll explain how we seek to avoid making this expensive mistake.
Investors want to be in a good position no matter which way the market moves. You might be surprised to learn that that’s not an unreasonable ask.
But I’ve seen lots of investors, with good intentions, putting themselves in terrible positions by overhedging.
The models we manage for our clients that use options to hedge against a volatile market like the one we’re currently experiencing, generally use approximately 3–7% of the bullish stock account.
Please read the last sentence again, and then I’ll explain…
Sometimes (like right now) we have put options in place to hedge against a decline. Put options have an inverse relationship to the price of the underlying stock or ETF.
The put options, therefore, act like “stock/ETF insurance.”
The put options we use are very sensitive to the price of the stock/ETF, so if it declines by 10%, that put option may hypothetically double, just as an example.
So if we buy put options – even just a small position – it can have a huge impact on the overall stock portfolio.
Let’s run through the math…
Let’s say we have an account valued at $100,000 with all bullish positions.
Then we take a small put options position and everything declines by 10%…
We’d have 95% of our account in bullish stock/ETF positions and 5% bearish put option positions.
The $95,000 in stock/ETFs declines by $9,500 and the $5,000 in puts gains $5,000 – it doubles!
Now we have $85,500 in bullish stocks/ETFs (declined 10% from $95,000), and $10,000 in puts (we sell those puts, so we now have $10,000 in cash).
That means the total account value is now $95,500.
Sure, we’ve lost some value, but when the rest of the world is theoretically down 10% in their stock account and sitting on a bunch of down positions, our hedged account is only down 4.5% and now we have $10,000 in cash.
Now we can find a good time to use that $10,000 cash to buy some oversold stocks…
This is a fantastic position to be in because everyone else is looking at these oversold cheap stocks wishing they had the cash to buy these stocks… and we do!
So to review…
- While others are down 10% with a $90,000 account and sitting on losing stocks wondering if they should sell to stop the bleeding and potentially miss the big rebound higher…
- We’re looking at a $95,500 account value, down only 4.5%, just looking at oversold stocks we get to buy cheap that everyone else wishes they could buy.
Our only decision now is whether we should use that $10,000 to buy sector ETFs, stocks, or call options.
Let’s say we then buy some call options…
If the stock market goes back up to where it was, that means it would have to go up by 11.11%.
Let’s say our newly purchased call options double from $10,000 to $20,000. And don’t forget our stock account also goes back up 11.11% to $94,999… so now we’re up to $114,990.50
So when everyone else is praying to god they’ll break even, our account value has gained another 15% points.
Now, a 15% gain doesn’t sound like a massive gain, but in reality, the stock market only gains about 7-8.5% annualized in a typical multi-decade period.
So scooping up an additional 15% on top of what you end up with in a year is HUGE…
That’s super powerful and we only used 5% of the account to hedge.
And you don’t want to go much further than that unless we go into a bear market, at which point we’ll consider a new strategy.
There’s also obviously a possibility that a hedged account goes up right after you hedge, and your puts decline…
Of course, you would feel bummed out, but the point of all of this is you only really need to do it on a very small scale (3-7%).
Even if the hedge is going in the wrong direction then it still feels great. It’s like owning insurance… if you buy life insurance and don’t die, you’re still happy and you’re happy your family was financially protected.
But for now, the long-term economic situation and the long-term financial market situation is VERY STRONG and VERY BULLISH…
But we will likely see sharp price dips… and if you want to enjoy it thoroughly rather than feel like a nauseating rollercoaster ride, this can be a great strategy.
If you’d rather do this strategy on your own, that’s fantastic, and I hope this article helps to guide you some along the way.
But if you have accounts that add up to more than $500,000, and want to talk to us at Rowe Wealth about having us do this for you, just click here for a free 1-hour consultation.
Talk to you soon,
P.S. Remember this is hypothetical – not the exact math we have in our models. Right now, the puts that we own for our hedged account are up, but they have not doubled. And we are not calling a short-term bottom yet, so it would be exciting to see how much lower the market could decline. Our stance is you might consider hedging your accounts before they decline more…
Get Our FREE Guide
How to Find the Best Advisor for You
Learn how to choose an advisor that has your best interests in mind. You'll also be subscribed to ADAPT, Avalon’s free newsletter with updates on our strongest performing investment models and market insights from a responsible money management perspective.