How to hedge your shares portfolio

• How can economic downturns affect your shares portfolio?
• Ways to hedge your stock portfolio
• Example of hedging shares
• Hedging shares summed up

How can economic downturns affect your shares portfolio?

Equities do the best during bull markets. A portfolio of equities is exposed to weakness in economic growth – when growth falls, employment declines and consumer and business spending drops. Equities are a means to benefit from rising corporate earnings, which are driven by consumers and businesses spending money. If earnings growth is expected to be negative, then investors tend to sell shares, driving down prices and causing bear markets (ie prolonged falls for share prices). A portfolio of shares will thus fall in value during periods of economic weakness.

It is important to note that economic downturns are usually short-lived. Since 1945, US economic expansions have lasted an average of 57 months, versus an average of ten months for economic downturns. Thus, periods of weakness are to be expected. Usually these times will see falls in share prices that result in good buying opportunities in the long term. In addition, a ‘dollar-cost’ averaging strategy can help smooth out the good and bad periods.

Ways to hedge your stock portfolio

'Hedging' is a process which seeks to reduce the overall risk on a portfolio by taking positions in non-correlated markets, or by opening short positions in markets that will result in profits that reduce the overall loss on a portfolio of equities during market corrections.

Owning investments across various categories can help to reduce risk, for example by buying other asset classes such as property, commodities or bonds. A well-balanced portfolio will avoid over-concentrating in one asset such as equities, and have some allocations to other assets that may see better returns in periods of economic weakness.

A second method is to increase allocations to ‘defensive’ stocks such as utilities, which tend to outperform riskier stocks during market corrections. This outperformance, and the strong dividends these stocks often pay, can help to reduce overall losses, although not eliminate them entirely.

A final method is to use short positions on equities or indices to profit from falling prices. This helps to offset overall losses on a portfolio, but care must be taken to manage risk and close out these positions when the market begins to rise once more.

Hedging by going short on stocks

In bull markets, investors should seek out the strongest performers. By contrast, bear markets, where stocks fall over time, should see traders looking to short the weakest performers. By going short on stocks, traders can help reduce the losses on the ‘long’ part of their portfolio. This can be done via CFDs, which provide access to a range of equities around the globe.

By using leveraged trading via CFDs, investors and traders can benefit from falling prices, and not have to worry about the need for currency changes. The profits made from these short positions may not offset the losses on the main portfolio entirely, but can act to reduce these losses.

Hedging with ETFs

Exchange Traded Funds (ETFs) allow investors to hedge their portfolio without using derivatives or other complex financial products. The low cost and easy accessibility of ETFs make them a more attractive prospect for some investors. An ETF that looks to be short a headline index such as the S&P 500 can be used to hedge a portfolio of long equities, as profits on the ETF are made when the underlying index falls. Again, like using short positions on equities, the use of such ETFs should be viewed as a means to an end, and not a permanent position.

Hedging with indices

Just as traders using CFDs can use short positions on individual equities to hedge their main portfolio, they can employ short positions on the indices themselves, in a similar fashion to the use of short ETFs. Again, the declines in the index see investors make profits on their short positions, although as before these short positions are more use as a short-term hedge in corrections or bear markets, rather than as long-term positions over many years.

As with shares and ETFs, the hedge is not designed to remove all the risk from a market decline, but to mitigate it. Since it uses leverage, it must be used in conjunction with a proper risk management approach, so that a sudden rally in the market does not result in a significant loss that renders the whole exercise in hedging pointless.

Hedging shares – an example

Client A has an equity portfolio worth £100,000. He expects the market to decline in the coming months, and opens a short position on the FTSE 100 to offset some of his losses.

Following the rules of correct risk management, can risk 2% of this account on the trade, ie £2000. Since this is a longer-term trade, he uses a wide stop of 200 points, so that his position size is £10 per point (2000/200). A 10% decline in the value of his portfolio is £10,000. If the FTSE 100 declines by 500 points, then he will make a profit of £5000, offsetting half his loss.

Hedging shares summed up

Hedging can be a useful means of reducing losses on an equity portfolio. It is not a means of eliminating losses entirely, but as the above example shows can help to cut back the losses. It is important to remember that periods of falling prices are usually temporary, and that bull markets tend to last longer than bear ones, so usually it is more beneficial to be long than short.

Hedging is a popular strategy for trading other asset classes too – including hedging forex positions, bitcoin risk and currency risk.