5 Ways to Hedge Your Stock Portfolio to Reduce Market Risk
Americans have always viewed stocks as excellent investment vehicles, and rightly so. According to data from Goldman Sachs, the average stock market return over ten years is 9.2 percent. That’s significantly higher than the inflation rate. Resultantly, if you invest in stocks wisely, you’ll see your net worth increase over time.
Stock trading and investing have long been popular. However, while many people try their hand at the stock market, few succeed. Stocks are inherently volatile. The markets shift multiple times daily. In some instances, you can even witness markets change by the second. Stock traders attempt to profit from market volatility. However, the reality is that risk accompanies volatility.
Traders and investors don’t want to lose their hard-earned money. Hence, they employ several risk management techniques to protect their investments. However, risk management is a challenging skill to master. It’s also something many new traders and beginners overlook.
Most seasoned traders and investors will advise you to hedge your bets. Beginners often don’t understand the importance of hedging their portfolios. However, if you don’t want to lose your investment capital, hedging is something you should seriously consider.
Stock exchange board
What is Portfolio Hedging?
Hedging is a strategy that aims to mitigate losses. You can hedge your portfolio in numerous ways. One of the most common methods is buying an instrument whose pric appreciates while the value of other instruments in the portfolio decreases. However, traders can also use options, derivatives, and other strategies to reduce risk.
A stock chart depicting price movements
Why Hedge Your Stock Portfolio?
Stocks are susceptible to changes from numerous influences. For instance, both internal and external factors impact stock prices. Macroeconomic factors like fiscal and monetary policies, exchange rates, and central bank decisions affect stock prices. Likewise, internal factors can also cause stock prices to fluctuate. These include earnings reports, new ownership, etc.
Resultantly, these factors can cause stock prices to shift substantially. Traders and investors want to protect their positions from volatility. Generally, they want protection from market risk instead of a specific risk. Hence, they hedge their portfolio to protect themselves from sudden shifts affecting their investments.
Ways of Hedging Your Stock Portfolio
You can hedge your stock portfolio in numerous ways. They include:
Diversification
Diversifying your portfolio is one of the most common methods of hedging. You can diversify your stock portfolio in multiple ways. For starters, you can purchase stocks in different industries to prevent the accumulation of stocks from a specific industry. Doing so protects you from industry-related risks.
Some traders and investors also like to use the Modern Portfolio Theory (MPT). Economist Harry Markowitz developed the theory in the 1950s. The MPT revolves around the idea that you can design a portfolio that maximizes returns while assuming optimal risk. The MPT accomplishes this by diversifying your portfolio acrossvarious asset classes. Therefore, if you want to follow this theory, you’ll need to invest in other financial instruments. That’s because the MPT argues that stocks are both unsystematically and systematically risky.
Holding Cash
Most experts don’t recommend holding cash for extended periods. That’s because cash loses value since you can’t earn returns on it. As inflation rises, you’ll lose buying power. However, in some instances, holding cash can prove beneficial. For instance, if you’ve got less money invested in your stock portfolio, you’re less likely to lose it if the market crashes.
Buying Volatility
You can also hedge by buying volatility. The Volatility Index Indicator (VIX) enables traders and investors to hedge. The VIX measures the volatility of calls and puts based on the S&P 500 index. You can use futures, ETFs, and options to trade the VIX index. Typically, volatility increases when the market corrects. As a result, instruments based on the VIX index rise when other asset classes fall. Consider purchasing volatility options and ETFs when the VIX is historically low. Generally, a VIX level below 20 represents low volatility, while above 30 shows high volatility.
Options
Options are an excellent way to hedge your bets. Investors can buy options to protect their portfolios from downturns. A long-put option is the simplest option for hedging. A put option enables you to sell an asset at a set price over a predetermined period. For instance, let’s assume you have stocks in a tech company. The current stock price is $45. You believe the stock price will fall to $30 in the coming months. By purchasing a put option, you can set a strike price of $40 over the next six months. Let’s assume the stock’s price decreases to $30 in three months. You can exercise your option and sell it to the put option holder for $40. By doing so, you’ve managed to reduce your losses.
Another type of option traders frequently use are call options. Call options enable traders to buy an asset at a set price within a given timeframe.
Collars are also popular options strategies for hedging risks. Collars encompass buying both a put option and selling a call option. By selling call options, you can cover the put option premium. However, while this strategy reduces risk, it also limits the profit potential.
Buying Products with Inverse Returns
Purchasing products with inverse returns is another way of hedging stock portfolios. You can buy commodities or other assets that are inversely related to stocks. For instance, many traders and investors consider gold as a safe asset. That’s because gold prices remain stable or increase when the economy suffers. Likewise, some investors like to supplement their stock portfolio with commodities trading or forex trading.
Stock prices on a smartphone
Hedge Your Stock Portfolio with Crystal Ball Markets
Hedging your portfolio is easier said than done. However, if you’re considering other asset classes, we can help you. Crystal Ball Markets is one of the top online investment platforms you’ll discover. We’re also one of the best index and stock trading platforms. In addition, we’re also an online forex and crypto broker. Visit our website to learn more. Alternatively, register with us today to get started.