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Many long-term investors are sitting on handsome winnings from the massive bull market of the last several years. Nearly everyone was riding high on bullish enthusiasm, and nothing seemed to go wrong. Investors were successfully buying dips as the stock market pushed to record high after record high. It was an actual golden age from the stock market to cryptocurrencies, as even beginners basked in sometimes steady and sometimes obscene profits.
Then the impossible happened — stocks started falling fast as investors scrambled to lock in profits by liquidating their holdings. While taking profits is always a smart move, it’s hard to not think about what would have happened had you held your shares.
The prevailing wisdom is that you can always buy back your stocks after taking profits. Of course, this makes sense, but it is tremendously challenging to execute. My hat is off to you should you not struggle to buy back at a lower price after selling.
On the other hand, professional stock traders and investment firms often hedge their long positions rather than selling to protect their gains. A well-managed hedge can protect your profits while allowing for upside potential in the stock.
Here are three ways to hedge your stock market profits.
Investors often erroneously believe that options are just too dangerous to consider. While this can be true if using options to speculate on directional moves, many option strategies actually reduce risk. In fact, the derivative market was first designed to hedge risk rather than embrace it.
There are three simple option strategies designed to protect your profits: covered calls, protective puts, and covered call collars.
Protective puts are the often the most popular way to protect your portfolio from downward moves. This strategy entails buying one put option per 100 shares, with a strike price at or near the trading price of the stock. Should the stock drop in value, the put is expected to increase in value by an equal amount, counteracting the stock price loss. In the end, the trader’s only loss is the original price of the put option.
Next, the covered call strategy is a well-known hedging tactic. This tactic sells call options on stocks in your portfolio. The strategy is so popular there are funds and even an ETF that use it as a primary investment tool. One call option is sold per 100 shares of stock. It is used when the trader feels bullish on the underlying stock but wishes to protect the downside or earn income from the call sale.
Lastly, the covered call collar is an easy to understand hedging strategy that uses options. It is a covered call strategy combined with buying a put option on the same stock. The option part of this strategy is called a combination. Collars are used to hedge when the investor has a neutral outlook on the underlying stock.
Futures are another investing tool that many stock market players avoid due to perceived risks. Make no mistake, futures are exceedingly risky due to their leverage, but they also make an excellent hedging tool for protecting your gains.
Some stocks have single stock futures available via the One Chicago Exchange. If this is the case, you can directly short the single stock future representing the stock you wish to hedge.
If your stock is not represented by a single stock future, or you wish to hedge your entire portfolio, futures exist on the Dow Jones Industrial Average and S&P 500 to short as a hedge against a market drop.
The E-mini Dow contract has the symbol YM while the S&P 500 E-mini is known as the ES. I personally like the DJIA E-mini contract the best for hedging. It is purely personal preference.
ETFs can serve a similar hedging purpose as futures for your stock portfolio. What I like about ETFs is their vast diversity. For example, there are ETFs for nearly every stock market portfolio. Let’s say you own a portfolio of China-based stocks. You can short an ETF representing Chinese stocks. The primary ETFs for a U.S. broad-based portfolio would be the DIA and the SPY, serving the Dow Jones Industrial Average and S&P 500, respectively.
There are ETFs known as inverse ETFs. An inverse ETF is designed to move in the opposite direction of the market. One can purchase inverse ETFs to hedge a downward move in a sector or overall market. However, be cautious because inverse or leveraged ETFs don’t always track the market as expected.
Risks To Consider: Hedging costs dig in to upside potential. Always consider market conditions and the need to protect profits before instituting any hedging strategy.
Action To Take: Consider hedging your portfolio as a viable strategy to help protect from downside.