Lewstherin posed an interesting question about protecting their portfolio on the "This is more than a correction....?" thread, and this is a general comment examining some potential approaches:
Originally posted by lewstherin:
Shorting is an option, but my problems with that are:
a) No experience shorting (nor with CFDs which I assume I need to use in order to short)
b) A lot of my capital is tied up in equities that have been hammered. My fear is I liquidate in order to short, and the market bounces at that point - so I get doubly screwed on the shorts and the losses I take to get into the shorts
This is a complex area involving a range of areas of expertise. One area is regarding derivatives and securities (re hedging, and shorting), but this may also have relevance to tax issues and superannuation.
I do have PS146 certification in derivatives and securities, but not in superannuation. I will not give any financial advice here however, and will not comment on superannuation or tax issues at all (since I don’t have certification in this area, and suggest consulting a suitably qualified advisor).
Let me just make a little caveat at the outset:
Disclaimer: Firstly I’d like to state that this is not financial advice, that this is purely hypothetical, and that I have not considered the financial situation of anyone reading this comment. Further that anyone wishing to embark on this kind of approach should seek appropriate financial advice including consulting suitably qualified advisors in tax, derivatives and securities, and superannuation, on the ramifications of any of the approaches ventured which may or may not be suitable depending on individual situations.
Also, I do not recommend any particular instrument over another understanding that different investors may have different goals, needs and risk profiles. No PDS is included since the comments are generic.
Warning! Please exercise caution using derivatives. These instruments require appropriate levels of knowledge to understand and use. I strongly suggest that investors/traders thoroughly inform themselves about how these instruments work, and consider consulting suitably qualified experts before making investment decisions. The purpose of the comments below are purely for general discussion, and should not be interpreted as financial advice.
My focus here is purely on some ideas for hedging positions. There are a range of approaches for protecting existing investments/positions. Key variable considerations are time, risk tolerance, tax exposure/profile, desired outcomes, and market perception (including expectations for different sectors – and perhaps commodities/interest rates/indexes/Forex). I’m assuming we’re talking Australian stocks…
Please also refer to the ASX site for definitions for the terms used below:
In this case we are assuming a significant drop in the market across the board. Assuming that the investor’s portfolio is suitably diversified (if it isn’t there are measures to balance the risk one could embark on using say buying shares or instalment/endowment warrants matched with a range of puts or short futures, or both, and selling over exposed positions down to mitigate risk), then an approach could be to purchase sufficient XJO puts to cover a downturn. It is tricky to match the correct amount of these contracts to a diversified portfolio since different stocks may move differently to the market. (There are formulas for these, but it can get complex, and I don’t have time to go into it here).
Stock Option Hedging:
An alternative would be to trim the individual stocks into numbers of shares divisible by 1000 (Australian option contracts are usually 1000 – unless there is a modification, in which case the number of shares should correspond to the contract amount). You could buy slightly out of the money puts (some loss in value would occur – the difference in the strike price bought and the current price, plus the premium per share), or buy at the money puts (which will be more expensive than the OTM puts).
Also, consider the time length you would like to protect your positions. Oddly enough, the longer the term, the more cost effective the time decay outlay, but the costs are higher in premium. You may wish to protect your positions for a month, 2 months, 3 months, or even a year or more.
A way to ameliorate the cost of the puts is to sell calls corresponding exactly to the number of shares for each stock in the portfolio. The danger here is that if the stock rises or is at or above the strike price of the call at expiry or as expiry nears, that the option to buy your shares may be exercised. This means the call seller is obliged to sell their shares at the strike price the calls were sold at. Provided the investor is comfortable with this prospect, this can often finance the puts at the cost of putting a cap on potential profits, and may in some cases yield revenue above the cost.
Another point to consider is dividends, and selling calls near the money around dividend time is asking to be exercised (usually the day before ex div!). Also note that put values appreciate approaching the ex dividend date (market makers employ a formula to increase the volatility of the puts in anticipation of the drop in value ex div, hence reverting to the normal volatility ex div).
The main problem with this approach is that volatility can add an extra layer of complexity, which is why you should be well versed in options theory, or get advice from an expert in this field. If volatility is high, your puts are going to cost more, but if you sell calls, you’ll probably get higher premiums too offsetting the high cost of the puts.
Alternatively you may consider selling share futures in line with your portfolio (this requires knowledge of futures, and access to the SFE), but again this would result in having to deliver your shares at the delivery date if you did not close the open futures contract. If the decline occurred, the contract value would depreciate meaning you would be making profits (since you are effectively short the future) while your shares lost value, hedging your share losses.
If the market appreciated, your gains in your shares would be negated largely by the losses as the futures appreciated (which since you are short the future – i.e. sold the future, if you wish to close the position, you would need to pay up to exit, at a loss). The advantage is that you can avoid the problems with closing share positions in some cases where CGT may be involved, but I suggest you consult a professional about this.
The net effect of this approach though can hedge the positions you have, but at a transaction cost, plus the inconvenience of having to make margin payments if the market appreciated to cover your short futures. To do this effectively you would need to calculate the exposure and ensure you had sufficient funds to cover any margin calls. The main aim is to protect positions from an adverse move, while still being able to collect dividends. The downside is losing any gains in value in the shares.
You may also consider using futures to deal with movements in particular commodities or indexes relevant to your portfolio, but this can be very risky, and you need to consider how to mitigate mismatches between stock positions and futures used for hedging – this can become quite complex when interest rates and currency considerations can materially effect commodity and index outcomes – particularly for overseas instruments – be careful!
You may also consider using CFD’s for quick action to deal with movements in particular commodities or indexes relevant to your portfolio if you don’t want to use futures, but these instruments have their own risk since they are not conducted in a regulated market, and the service provider presents as a potential credit risk if it becomes insolvent. Essentially you’d short a matched position to your shares, or go long or short sectoral indexes, commodities or Forex contracts corresponding to your portfolio mix – but this requires considering the net effects of a range of variables, and there is a real risk of mismatching the price movements between stocks and other instruments.
I’m not going to comment much about this area since I have limited knowledge on the subject, but there are basket style funds and trusts etc that can spread risk, but these are involved investments that should be discussed with an expert advisor for more information.
The Short side of the market using Options (non superannuation):
Looking at the short side of the market, speculators may just buy puts, or sell calls (suggest hedged – e.g. bear call spreads, or ratio positions) for example. There are also a range of strategies that can be used based on volatility, liquidity, and the nature of existing portfolio positions and time frames (this is a vast subject – happy to chat more if anyone is interested, but not as financial advice, only in generic strategy terms).
There are also put warrants available, but this is another kettle of fish since OTC (Over the Counter) markets are not regulated like ETO’s (Exchange Traded Options), and each issuer has their own terms and conditions (and credit risk if the issuing organisation can’t honour the warrant for any reason).
The approaches above are all about controlling risk. The aim is to assess the risk and reward of strategies, and assess the potential for success, based on the investor’s risk tolerance.
I hope this gives some food for thought.