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Hedging a Stock Portfolio - Hedging Strategies for a Market Crash - YouTube
Channel: Learn to Invest - Investors Grow
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hey YouTube I'm Jimmy in this video I'm
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gonna walk through hedging a stock
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portfolio and we're gonna look at how it
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could go about saving us a fortune I'm
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going to examine some of the most
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popular forms of hedges and then we're
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gonna look at their actual track records
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based on some of the more recent market
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Corrections now
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I recently did a video called five tools
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to predict a stock market crash and in
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that video I mentioned that if you are
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afraid of a market crash or even a
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pullback well you can always head your
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portfolio and then one of the
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subscribers posted a comment and he said
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how would I go about setting up a hedge
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and I thought well that could really
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make a great video since it could save
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investors a ton of money and since we
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care about how executable something like
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this would really be I decided to
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analyze different hedges and how
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strategically they could be used in
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today's actual environment and to do
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that we're looking at some of history's
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more recent collapses okay so here it is
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so first let's start with the very
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basics what is a hedge well at its core
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a hedge is something you would add to
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your investment portfolio that in theory
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you should profit if one of your assets
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goes down Vanessa should profit so
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theoretically diversification is
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striving to do the very same thing in
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fact diversification would be a form of
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a hedge because imagine you won't let's
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say nothing but energy companies and
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then oil collapses like it did back in
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2015 well if you only own energy
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companies your portfolio is going to get
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crushed now I did a whole video on
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diversification so if you haven't seen
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that or if you're not sure what
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diversification is that might be a good
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place to start and you can see a link to
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that in the description below
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but for the case of this video I'm going
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to assume that you have a diversified
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portfolio I'm going to assume it's all
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US stocks and we're going to look to set
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up hedges we're gonna examine which
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hedges will be best assuming we have a
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u.s. stock portfolio so first let's look
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at gold gold is a very popular hedge
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here's a price chart 5 years looking
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back at what gold is done recently
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so my first observation is that gold
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appears to be quite volatile and perhaps
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that's ok especially since the price of
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gold is down recently to run around
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$1200 and we could see that not too long
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ago it was slightly above 1350 and and
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that was only in April of 2018
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so the concept behind gold being a good
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hedge is that it's a defensive play
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particularly against inflation and often
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times when the market Falls investors
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retreat to what they deemed to be a
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safer investment in gold from many
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investors is often near the top of that
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list so the test if gold is really if it
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really works as a good hedge then what I
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did is I examined gold relative to three
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significant market pull backs in recent
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history
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so the first pullback I'm going to look
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at is the oil collapse that lasted from
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mid 2014 till early 2016 and if you
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don't remember well oil fell from a high
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up here of about 107 dollars of barrel
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to about $26 a barrel in early 2016 now
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if we had the S&P to that we can see
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that SP didn't do as bad as oil did but
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you can see that SP didn't exactly do
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great during this time that's why I'm
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including it so now what happens when we
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add gold so to keep this chart from
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getting too cluttered I'm actually
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eliminating oil we're keeping the
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timeframe but we're just gonna eliminate
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oil so the orange line is the S&P 500
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the green line is gold and as you can
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see gold actually didn't do that great
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during this time period but what's
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interesting to note is that when we zoom
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in a bit we can see that on more
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volatile days like right here
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well the SP fell in gold sharply went in
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the other direction and then
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happened a few times now this particular
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market correction may not be the best
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example for gold since oil is a hard
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asset and gold is also a hard asset and
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in theory they may not act terribly
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different from each other although this
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was a very oily pull back but frankly
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we've been in a long bull market so it's
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been tough to identify pull backs that
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being said our next one we went back to
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await to see what happened with gold in
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the Great Recession so for the ohwait
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collapse we're gonna take from about the
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middle of May in 2008 which is right
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near the market high and we're gonna go
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push forward till about March of 2009
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which was right near the market low now
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when we add gold for that same time
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period well once again we can see that
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gold was very volatile much like it was
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when we were looking at the oil collapse
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and it did end the whole period from
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here to here higher which means that if
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it was in your portfolio as a hedge it
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would have helped offset losses although
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it would have been a very volatile ride
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as you can see during the whole thing
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and to me it's interesting that these
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two charts the sp500 and gold almost
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look nothing alike
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I mean gold at different times is moving
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higher while the SP was moving lower but
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then they were also moving together at
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the very same time if you look at this
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area so for me they seemed somewhat
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uncorrelated okay so now let's jump back
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to the tech bubble back in 2000 this
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chart goes from the high in about March
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of 2000 to the low which happened in
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October of 2002 now this is what a hedge
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looks like frankly I was sort of
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expecting this type of chart back in the
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Oh it collapse and as we can see here as
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the S&P 500 fell gold rose and it looks
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like gold reacted as you would expect a
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hedge to act when the market is pulling
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back when the SP boosted higher in any
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one moment gold fell and vice-versa so
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in this scenario looks like gold was
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more beneficial since it looks to be
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more negatively correlated so now
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there's a quick way to see a summary of
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how gold
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benefitted each portfolio if you look at
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this table here you can see that the
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correlation is negative for each of the
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three market Corrections that we looked
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at between the sp500 and gold and as I'm
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sure you could have guessed from the
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charts the tech bubble was be most
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negatively correlated which in theory
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would mean that would have benefited the
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portfolio the most although because each
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one was negatively correlated that would
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really be a good thing as a hedge so
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overall it looks like gold would provide
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hedge benefits to a stock portfolio at
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least according to these three market
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Corrections okay so for our second hedge
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we're gonna look at cash now you might
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not think of cash as a hedge but I'd be
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willing to guess that this is probably
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the most popular of all hedges and it's
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probably my least favorite as well so
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what I mean by cash is I mean that
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you're afraid of a market pullback so
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you sell all your positions and you hold
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cash instead now if you think about it
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from that perspective then perhaps you
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can see how cash could be used as a
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hedge basically your forfeit upside
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since you're no longer invested and in
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return you don't have any downside risk
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also since you're not invested but since
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we're investors you might also guess why
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don't really like this strategy to me
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this is market timing sure going to cash
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is great if you're right about it but
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when you're wrong well then you're just
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sitting on the sidelines and to me that
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doesn't make any sense
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see if I had a crystal ball and I knew
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the market was gonna get cut in half
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tomorrow well even then I wouldn't go to
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cash I would probably buy a put option
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or something else some other way that
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perhaps I could turn my knowledge that
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this is going to crash into some profit
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and this brings me to our third possible
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hedge which is also my favorite using
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put options so if you're not sure what
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put options are you can see my I did an
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investing basics video and you can see a
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link to that in the description below
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now basically if you buy a put option
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you profit when the underlying security
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now how the best way to actually execute
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this type of strategy would vary from
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portfolio to portfolio depending on what
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each portfolio had in it but for our
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sake let's imagine that you only had one
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investment and that investment let's
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pretend you owned an ETF tied to the S&P
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500
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well in this case hedging is a bit
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simpler because you only have one
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holding and if we were to go out and buy
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put options on the S&P 500 ETF then in
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theory that would hedge our entire
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portfolio so let's have a look at how
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that would work so for our example I'm
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going to imagine that we own s P Y which
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is a spider SP 500 ETF now as I shoot
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this video the SP Y is trading at about
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280 $3.75 and where we bought SP Y is
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somewhat irrelevant since in this
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example I'm gonna walk us through what
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were to happen from what would happen
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today forward so if you bought that at
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$100 good for you you're up huge but my
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real concern is what is it going to do
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from here forward so that's why I'm
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somewhat ignoring what our cost was for
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us where we are today - what we do with
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the put options how does it look now the
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key with put options the thing to
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remember is that when you buy them you
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pay a premium today and in return for
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that premium you have the right to sell
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100 shares in this case of SP y at a
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predetermined price called the strike
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price by a predetermined date they call
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that the expiration date so based on the
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current price let's look at some real
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examples and for the sake of keeping the
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numbers real let's imagine that we own a
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hundred shares of SP baht so right now
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our hundred shares is worth twenty eight
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thousand three hundred and seventy-five
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dollars and since options trading groups
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of 100 will only need one option so
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today's date the data I'm filming this
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it's August 14th 2018 and once again SP
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y is currently trading at about two
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hundred eighty three dollars and seventy
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five cents so let's pretend that I think
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a market collapse is about to happen I'm
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certain of it the crystal ball she told
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me that the collapse is going to happen
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yeah I made
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Cristobal girl so perhaps I'm so
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confident that a crash is coming that
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I'm going to go ahead and buy put
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options that expire in the middle of
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September just a month away
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[Music]
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so here the prices for the September
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options and when you look at an options
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quote you can see that it's quoted per
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share so if I wanted to buy the $283
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puts I pay two dollars and sixty five
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cents which is $265
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now before we analyze the individual put
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option choices
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my concern is obviously the accuracy of
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my crystal ball I love her but she's
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been wrong before so what if she's wrong
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again so to protect myself a bit I'm
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gonna consider going out a bit further
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as far as time is concerned so now I've
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added the prices for January of 2019
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which is just a few months away and also
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the prices for put options that expire
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in September of 2019 so when we look at
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these prices obviously the first thing
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that jumps out to me is the how
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dramatically the prices increase so if I
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buy the September of 2019 puts I'm
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paying fifteen hundred and ten dollars
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for put options with a $280 strike price
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so let's plug that one out for a second
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just so we can see how this would work
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if we were to add these to our portfolio
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today so we buy this put option this one
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put option gives us the right to sell
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our 100 shares of SP y at $280 and for
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that right we're willing to pay the
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seller of the put option fifteen hundred
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and ten dollars today so scenario one
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the market doesn't fall in fact it keeps
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moving higher
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[Applause]
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okay so let's imagine on the day of
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exploration yes spwhy is trading at $300
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a share okay interesting
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now scenario two same day in the future
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but instead she was right yes sp why did
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fall and it's down to two hundred and
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fifty dollars a share let's look at how
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these scenarios play out so in Scenario
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1 the market moved higher and SBY on the
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day of exploration is currently trading
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at $300 a share well we spent fifteen
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hundred and ten dollars to protect us on
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the downside and it turned out to be
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unnecessary so instead of our portfolio
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being worth thirty thousand dollars
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which is the $300 per share times on 100
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shares that we own well it's only worth
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twenty eight thousand four hundred and
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ninety dollars which is we can thank the
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fifteen hundred ten dollar expense that
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we added so in this case the hedge
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turned out to be nothing more than an
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expense okay
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now on the flip side in scenario 2 s py
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fell down to two hundred and fifty
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dollars per share so are two hundred and
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eighty dollar put options are now thirty
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dollars in our in the money so I'm going
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to assume that they're going to be worth
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thirty dollars and that would mean that
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the value of the put on the day of
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expiration is three thousand dollars but
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we still paid the fifteen hundred ten
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dollars to get that right so instead of
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the portfolio only being worth twenty
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five thousand that it would have been
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worth without the hedge well it's
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actually worth twenty-five twenty-six
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thousand four hundred ninety dollars now
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this brings us to another important
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point when considering how to put on a
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hedge this particular put option was $30
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in the money when it fell from two
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hundred eighty down to two hundred fifty
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and that's quite good but because we've
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selected a put option that was so far
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away as far as time is concerned a lot
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of the value of that fifteen hundred and
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ten dollars that we paid was time value
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and if our scenario let's pretend our
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scenario had ended just a week after we
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bought the put option well most of the
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time value would have still been in
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place and we could say that the put
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option would have been worth let's say
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$40 per share we still would have spent
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the fifteen ten but if it had happened
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sooner it would have been worth
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significantly more so another option
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that I've seen work out for people
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is to buy shorter-term options and keep
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rolling them over so in our original
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example if we look at the original
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prices that we had pretend that we
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didn't buy this one but instead we
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bought this one which expires in a few
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months in January of 2019 don't forget
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it's currently August so just a few
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months away well then we're paying only
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seven dollars and 85 cents which is $780
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five dollars for the whole contract now
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if the pullback happens during that
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while our profit will be even larger
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assuming the same pullback happened but
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let's pretend during that time period
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the market actually keeps climbing
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higher and we're still worried about a
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pullback and instead of the current
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price currently being 283 75 which is
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where it is today
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pretend in December the it's trading at
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293 well where we bought the $280 put
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options here in theory we could buy the
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290 dollar put options in December
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before this one expires so we always
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remain hedged
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[Music]
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so the wrap-up put options as a hedge
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well you can see that there are many
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different ways to use put options to
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work in your favor now I used a super
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basic example where your entire
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portfolio was one holding which seems
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very unlikely most people probably
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wouldn't have that but let's imagine
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that you're holding stocks like Facebook
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and Netflix and Amazon and you can say
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that you know these holdings represent
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30 40 or 50 percent of your portfolio
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well you could always buy options on
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just those three holdings because then
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in theory your largest holdings would be
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hedged or perhaps you find an ETF that
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has each of those holdings in there and
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then you could hedge let's say that
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portion of your portfolio so it's not
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always that your entire portfolio needs
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to be hedged so here's another
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interesting choice which is actually in
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line with the same example of hedging a
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specific sector but in this case what if
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we were to put on a hedge on what we
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think would most likely struggle in the
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event of a market pullback so what what
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stocks look the most overpriced if you
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go back to the tech bubble well it would
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have been tech stocks if you go back to
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the 2008 crash well it would have been
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banks that crashed the hardest if you go
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back to the old crash that happened in
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2015
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oil stocks would have crashed the
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hardest so in theory if we could
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identify which companies are running
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sky-high right now and if the market
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were to break hypothetically
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those would break the hardest and if you
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happen to have a well-placed put option
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or two or three or five or ten on the
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companies that are most likely to break
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well you could make a fortune if they
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did in fact fall the hardest so my
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question to you is are you currently
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hedged are you currently worried about a
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market crash and if you are hedged
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how are you hedged do you like the
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hedges that we talked about here would
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you do it differently let me know what
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you think in the comments below and if
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you made it this far in the video I
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really do appreciate you sticking with
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me all the way to the end and don't
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forget to hit this
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subscribe button and hit the thumbs up
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and I'll see in the next video
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