As we kick off another week on the market, I’ll be honest … I’m not entirely sure what to expect in the days ahead!
Just last week I was anticipating the start of a market pullback, but the recovery into the weekend seemed to be telling me “Not today, pal!”
Of course, no one completely knows what the market will do … ever.
If anyone out there was right in their predictions 100% of the time … we’d certainly have heard about it by now!
So in times like these, what are your options? (Pun intended!)
Hedge Your Bets
Well, sometimes it’s good to give yourself a little wiggle room in either direction.
In this case, “wiggle room” refers to hedging strategies that will help protect your investments in the case of a sudden upset, whether that’s an overall market pullback, or an individual equity suddenly taking a nosedive.
Hedging is basically a form of “insurance” for your portfolio that helps reduce your exposure, and can help lessen the impact of a catastrophic event. The drawback is hedging has costs, and therefore can reduce your potential profits.
Hedging usually involves the purchase of derivatives, such as put options or futures, that go against another current open position in your portfolio.
For example, if you’re long on stock XYZ, you might purchase XYZ put options to help protect your investment if XYZ suddenly tanks. The put option allows you to sell your shares at a minimum price, limiting your potential losses.
Of course, that’s a rather simplistic example, and there’s lots of hedging strategies to choose from, including buying and selling puts and calls to help you not only hedge your investment, but to also help cover the cost of your hedge.
Of course, unlike options, equities such as stock holdings don’t have an expiration date.
To combat this discrepancy, you can roll your hedges.
Roll It Over
Rolling hedges involves moving your hedge positions forward into the future. If your option is nearing expiration, but you’d still like to keep your hedge position, you would want to do this to buy yourself more time.
To roll a hedge, you simply close your current contract (usually at or near the expiration date) while opening a new contract. This pushes back the expiration date, and buys you more time on your hedge contracts.
By not holding a contract into expiration, you won’t see all of your options’ time value dissipate, and you won’t be assigned shares.
Besides expiration, another reason a trader might choose to roll their options is to take profits.
Obviously, collecting short-term gains on a hedge doesn’t mean you need to rid yourself of the investment that hedge was protecting. (Remember, that’s what rolling is for!)
For example, if stock XYZ takes a dip after a C-Suite shakeup, that doesn’t necessarily mean you don’t want to own XYZ.
But if your protective puts become profitable on stock XYZ, don’t leave that money on the table …
If the underlying equity decreases in value, for instance, a trader could close out a put at a higher strike, take profits, and re-open their position at a lower strike, gaining both profit and additional time in the hedging contracts.
After all, if you don’t take profits from your hedge when you can … what’s the point in hedging?
And besides being good sense, deep in-the-money options often have less liquidity. Since you typically don’t want to hold your hedged position until expiration, liquidity is something that should be taken into account, as you’ll eventually want to exit your position.
Additionally, snatching profits where you can helps offset the costs associated with holding your positions.
Hedging is an excellent risk management tool, although hedging strategies can get quite complex. It’s always important to take into account option pricing, expiration dates, and target profit/loss levels when you’re considering a hedging strategy.
But if you do it right, it can make market conditions like these very profitable indeed!
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Your Only Option