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The (Three) Best Hedging Strategies

By:Dr. Jim Schultz

How to hedge your portfolio against big market drops

  • Long puts are the classic way to hedge a portfolio against market drops—but they are expensive.
  • Short delta can protect a short premium from volatility expansion because huge volatility spikes are often accompanied by big market drops.
  • Staying small is the most effective way to hedge a portfolio organically.

There’s lots of talk about portfolio hedging strategies in passive investing and even in active trading. With the market’s elevated volatility over the last two years, many traders are more interested than ever before in protecting their portfolios. Here are three strategies you can put in place today.

Long puts

Many investors think long puts are a good strategy to add to a long stock portfolio because these puts can act as insurance if the market drops. That’s certainly correct—long puts pay off nicely if the market falls shortly after you add that long put. But given the high velocity of down moves in the market, puts are priced accordingly. So, generally speaking, long puts are expensive, which makes them the least attractive option of the three.

Short delta

Holding short delta (especially static short delta) can serve as an effective hedging tool for a short premium portfolio. Similar to a passive investor holding a long stock portfolio, an active trader holding a short premium portfolio is most exposed to big drops in the market. That’s because big drops in the market are often accompanied by large spikes in volatility, and short premium positions are hurt by rapid volatility expansions. Therefore, any short delta you might hold in your portfolio will benefit from falling market prices and thus soften the blow from rising volatility. The difficult part is the market naturally wants to rise over time, so fighting that flow can be costly.

Staying small

By far and away, the most effective way to hedge your portfolio organically is through position sizing. You can certainly layer additional hedges on top of position size, but you’ll never feel that any of them are required. With smaller position sizes, you will naturally be better prepared to handle any of the wild moves the market might send your way. You’ll also be far better positioned to follow the mechanics more objectively, and let the probabilities play out over time—leaning more on duration over time instead of directional correctness in the moment. 

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3 

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