How to Hedge Your Portfolio for a Market Sell-Off

The 2019 end-of-year market melt-up has been pushing the major benchmark indexes to new all-time highs literally daily. Pundits argue markets are getting closer to the proverbial edge of a market cliff. Whether you believe the bull market continues through 2020 or recession kicks in, it’s prudent to remain flexible and be aware of the many ways to hedge your portfolio during market downturns. The range of complexity varies from adjusting your asset class allocations to delta hedging. While there are no perfect hedges, the goal is to protect gains while minimizing losses comparable to the benchmark indexes. Here are some of the methods to consider depending on your situation.

Method One: Rebalancing Asset Classes

This is the most passive method with the least about of activity. After a nearly 30-percent gain on the S&P 500 in 2019, investors should consider rebalancing portfolio asset classes with greater concentration in fixed income and cash. While this may seem conservative, consider it more so building up a cash war chest to buy back at cheaper prices. The key point here is exposure. You can’t lose what you don’t have exposed. Cash is king. Pension funds must rebalance portfolios as per mandate, this means they shave down winners and average in on the losers to meet original allocation percentages. If your allocations in 2019 were 70-percent stocks, 20-percent fixed-income, 10-percent cash, consider swapping out stocks for fixed-income and cash (IE: 50-percent stocks, 25-percent fixed-income, and 25-percent cash). Having an incremental trigger where cash allocation increases for X-percent market decline is prudent. For example, allocating an extra 5-percent to cash for each 2.5-percent market decline.

Method Two: Covered Calls on Core Holdings

Using options contracts requires having options permissions from your broker. For long-term core stock holdings, consider writing covered calls to collect “rent” premium and buffer some downside risk. Depending on your holding time frame, you can select strike prices weekly, monthly or quarterly. This takes some experience with chart analysis to determine key resistance and support levels ahead of time. If the stock starts to severely sell-off, you can collar the position by purchasing puts with the call premiums thereby creating a low-cost collar depending. Once again, it’s critical to be aware of support and resistance levels on wider time frames like daily, weekly or monthly charts.

Method Three: Index Beta-Hedge

This is a method short-selling to hedge your long portfolio with a benchmark index. First, determine which index your portfolio correlates the best with. For most balanced portfolios, the S&P 500 index (NYSEARCA: SPY) should be suitable unless your portfolio is overloaded with technology stocks, then consider the Nasdaq 100 (AMEX: QQQ). The key factor here is to calculate your portfolio beta by multiplying the allocation percentage of each individual holding by its beta to derive the average beta. Multiply the total dollar value of the portfolio by the average beta then divide that amount by the price of the SPY or QQQ (if using that index). This is how many shares of the SPY or QQQ need to be sold short to hedge your portfolio. For example, if your $100,000 portfolio has a beta of 1.17 and the SPY is trading at $321, then you would need to short-sell 365-shares of the SPY to beta hedge it. 

Pay Attention to the VIX

Keep an eye on the CBOE Volatility Index (VIX) when it drops in the 12-to-11 range. This range typically indicates complacency in the markets and overbought conditions spurring market sell-offs. Oversold conditions tend to trigger around the 20-24 range on the VIX. When the VIX falls under 12, it may be prudent to consider placing an index beta-hedge until it recovers back towards 17-20 range. However, there are periods of extreme volatility where the VIX may spike through the 30-40 range so it’s also prudent to be familiar with technical analysis.

Correction or Bear Market

Keep in mind that a 10-percent sell-off from the highs is considered a correction. A bear market is a 20-percent or more sell-off from the highs that extends for more than 60-days. It’s prudent to have a system ready when these levels are tested or breached. The bottom line is to be able to react rather than attempt to predict when markets rollover. As they say, it’s better to have a gun and not need it, than to need it and not have one.