Hedge your investments

Now Is a Great Time To Hedge Your Investments

U.S. investors have it good these days. Stocks are hitting all-time highs. Meanwhile, volatility is exceptionally low. According to the Wall Street Journal, the last 30 day period has been the quietest in over 20 years! That tells me that now is a perfect time to hedge your investments.

What Does It Mean to Hedge Your Investments? 

Hedging your investments simply means that you take a position that would generate a profit if your other investments trade lower. The hope is that if the market turns against you, this “hedge” would offset your existing positions.

Think of this like an insurance policy.

When you buy an insurance policy for your house, you’re paying for financial protection in case calamity strikes. If a fire or flood ruins your home, the insurance policy pays off.

With most insurance policies, you hope you don’t have to use it. In fact, the best case scenario would be that you lose money on your insurance policy. If everything goes well with your home, you’ll pay the insurance company for protection and never collect a penny back.

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Of course if something bad happens, you’re glad you own it.

Did you know that you can buy an insurance policy for your stock market investments too?

Many investors buy put contracts for a broad stock market index as a way of insuring against a market drop. This is one of the ways that I protect my own family’s wealth. And it’s something that you should consider if you have money in the market.

Why Now is the Perfect Time to Hedge

Buying put contracts is usually a losing strategy. That’s why I don’t recommend buying put contracts to speculate on a stock or a market dropping. The odds are just too high that you’ll lose money.

But buying put contracts to insure your investments is another matter entirely. Remember, you expect to lose money on an insurance policy. But you’re glad that you have one if something goes wrong.

This is an especially good time to buy put contracts as insurance. That’s because the price you must pay to buy put contracts is exceptionally low. This has a lot to do with the low volatility (or lack of movement) for stocks lately.

The price of put contracts are tied directly to how active stock prices are.

If stocks are trading in wild, erratic movements, put prices will generally be high. But if stocks are quiet with very little movement, put prices will be low. Check out the chart of the CBOE Market Volatility Index (VIX) below. This chart measures the expected volatility for large cap US stocks.

VIX Chart (Source: TradeStation)

Notice how expected volatility has been exceptionally low for several weeks now.

Low volatility correlates with low put prices. Meanwhile, stocks are trading at expensive valuations and could be poised to drop.

Those two facts together make now a perfect time to hedge your investments.

Two Rules For Hedging Your Investments…

When I use puts to hedge my investments, there are two rules that I always follow:

1: Always use broad market put contracts

I buy puts on broad market ETFs (rather than on individual stocks) for one simple reason. I’ve done extensive research on all of my individual stock investments. So my biggest risk is that the market trades lower causing me to take losses.

I’m less worried about factors that could affect my specific stocks. That’s simply because I’ve already done my due diligence.

2: Always buy long-term puts as a hedge

The reason I buy long-term put contracts (instead of short-term insurance policies) is that it takes longer for these hedges to expire.

If you buy long-term puts to hedge your investments, you can have more time with your investments protected without having to renew your insurance contract (or buy more puts) over and over. I’ve found that long-term puts give you more protection value for the money you spend.

…and Two Hedge Options To Consider

Here are two put contracts that you could consider to hedge your investments:

  • Buy IWM June 2017 (quarterly) $120 Puts near $7.00 

The iShares Russell 2000 (IWM) ETF tracks the price movement of the Russell small cap index.

Buying puts on small cap stocks can be an excellent hedge because when traders become fearful, small cap stocks often drop faster than large cap stocks.

So if you use IWM puts to hedge your investments, you may get more profits from this trade if investors become fearful.

Each IWM put contract represents 100 shares of IWM. Since each $120 put contract gives you exposure to 100 shares of IWM at $120, you can effectively hedge roughly $12,000 of market exposure with each put contract.

  • Buy DIA June 2017 (quarterly) $180 Puts near $9.40

The SPDR Dow Jones Industrial Average ETF (DIA) tracks the price movement of the Dow.

Buying puts on large cap stocks may be an excellent hedge if the Fed begins to hike interest rates. That’s because the Dow is full of dividend paying stocks that have been attractive to income-hungry investors.

If higher rates make it easier for these investors to collect income from traditional deposit accounts, money could flow out of dividend stocks. This could cause the Dow to trade down rapidly, giving you a larger profit from your Dow put insurance contract.

Since each DIA put contract represents 100 shares, a $180 put contract can effectively hedge $18,000 of traditional investments.

Remember that these contracts act as insurance policies. So in my opinion, you shouldn’t be disappointed if you buy long-term put contracts and lose money. If this is the case, you should be generating exceptional income and profits from your more traditional investments.

Zach Scheidt