Hedging - Protecting Your Portfolio

With the Aussie bourse or more correctly the ASX/200 index in a consolidation or mini-correction period and with the prospect of Asian and US markets causing relatively large fluctuations in our local market, we thought it prudent to re-visit hedging strategies for your share portfolio.

What is hedging and why do it?

Hedging is the use of financial instruments in the active protection of a portfolio value. Therefore, if you are concerned that your portfolio value may drop due to adverse price movements then you may want to take steps to ensure that you can insulate it from the worst excesses. Although hedging has a cost, it may be preferable to either doing nothing, which could see the value tumble, or liquidating the portfolio, possibly exposing you to capital gains tax and also losing potential dividends and franking credits. It may also be the case (dependent on your tax situation, please seek professional advice) that the costs of hedging could be tax deductable.

How to Hedge

There are several methods of hedging a portfolio, the most common are;

Exchange traded options

One of the more popular hedging tools, Exchange Traded Options (ETO's) are either 'Calls' or 'Puts' that you sell or buy depending upon what you wish to achieve. For example, if you have ANZ bank shares and today (13/11/07) they were trading at $28.35, it would be possible for you to guarantee, in the worst case scenario, that you could sell them for $28.00 at the end of Januaryy 2008 by buying 'put' options for $0.90 per share (plus brokerages and fees). Therefore, if the price of ANZ dropped by more than 3% between now and the end of January 2008 you would be better off than if you otherwise had not purchased those puts. . More detailed explanations of using Options as a hedging tool can be found in the following articles;

Put Options as Insurance
Popular Option Strategies for premium generation
Covered Call writing

CFDs

Many of you may be familiar with the concept of Contracts for difference (CFDs). with CFDs it is possible to hedge the exact composition of your portfolio (Options have to be traded in parcels of 1000 shares). You would do this by short selling a CFD for every corresponding share in your portfolio. There are transaction and interest costs associated with CFD trading, however, there is no fixed date of expiry (as opposed to Options) and you are therefore able to terminate the hedging when you require.

Short Selling similar shares

Obviously you cannot short sell a stock you own without losing ownership and the benefits that brings, however, if you do not wish to open an Options account or a CFD account then it may be possible to short sell a stock that is in a similar industry. for example if you hold Westpac bank you could potentially sell Commonwealth Bank, therefore a drop in Westpac value could potentially be offset by the gain you make selling Commonwealth. In essence this is a pairs trade that we have covered in another Knowledge bank lesson; Pairs Trading, a market neutral strategy

Balancing your portfolio

This is not strictly hedging, but it is common sense! for example; if your portfolio is weighted towards speculative resource stocks then you may wish to increase the proportion of blue chip stocks such as the big four banks that traditionally fare better in turbulent times.