How to hedge your shares portfolio
We look at how investors can hedge portfolios to potentially reduce losses in times of market turmoil, such as the period of uncertainty that has surrounded Brexit.
Ways to hedge your stock portfolio
'Hedging' is a process which seeks to reduce the overall risk on a portfolio by taking positions in non-correlated markets, or by opening short positions in markets that will result in profits that reduce the overall loss on a portfolio of equities during market corrections.
Owning investments across various categories can help to reduce risk, for example by buying other asset classes such as property, commodities or bonds. A well-balanced portfolio will avoid over-concentrating in one asset such as equities, and have some allocations to other assets that may see better returns in periods of economic weakness.
A second method is to increase allocations to ‘defensive’ stocks such as utilities, which tend to outperform riskier stocks during market corrections. This outperformance, and the strong dividends these stocks often pay, can help to reduce overall losses, although not eliminate them entirely.
A final method is to use short positions on equities or indices to profit from falling prices. This helps to offset overall losses on a portfolio, but care must be taken to manage risk and close out these positions when the market begins to rise once more.
Hedging by going short on stocks
In bull markets, investors should seek out the strongest performers. By contrast, bear markets, where stocks fall over time, should see traders looking to short the weakest performers. By going short on stocks, traders can help reduce the losses on the ‘long’ part of their portfolio. This can be done via CFDs, which provide access to a range of equities around the globe.
By using leveraged trading via CFDs, investors and traders can benefit from falling prices, and not have to worry about the need for currency changes. The profits made from these short positions may not offset the losses on the main portfolio entirely, but can act to reduce these losses.
Hedging with ETFs
Exchange Traded Funds (ETFs) allow investors to hedge their portfolio without using derivatives or other complex financial products. The low cost and easy accessibility of ETFs make them a more attractive prospect for some investors. An ETF that looks to be short a headline index such as the S&P 500 can be used to hedge a portfolio of long equities, as profits on the ETF are made when the underlying index falls. Again, like using short positions on equities, the use of such ETFs should be viewed as a means to an end, and not a permanent position.
Hedging with indices
Just as traders using CFDs can use short positions on individual equities to hedge their main portfolio, they can employ short positions on the indices themselves, in a similar fashion to the use of short ETFs. Again, the declines in the index see investors make profits on their short positions, although as before these short positions are more use as a short-term hedge in corrections or bear markets, rather than as long-term positions over many years.
As with shares and ETFs, the hedge is not designed to remove all the risk from a market decline, but to mitigate it. Since it uses leverage, it must be used in conjunction with a proper risk management approach, so that a sudden rally in the market does not result in a significant loss that renders the whole exercise in hedging pointless.
Hedging shares summed up
Hedging can be a useful means of reducing losses on an equity portfolio. It is not a means of eliminating losses entirely, but as the above example shows can help to cut back the losses. It is important to remember that periods of falling prices are usually temporary, and that bull markets tend to last longer than bear ones, so usually it is more beneficial to be long than short.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
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