Whether you are making investments for your long-term future or are a financial trader playing the market for an ongoing profit, the risk is a constant factor in your dealings and acquisitions. While risk cannot ever be eliminated, it can be managed, often by using hedging strategies or tools that will hopefully reduce systematic or market risk to a level that you are comfortable with.
Market risk affects the overall market rather than a particular asset or security. It is a measure of factors outside of your control that impact the entirety of the stock market, currency exchange, or on whichever market you happen to be trading. It’s of little consolation that other traders will be in the same boat when volatility hits, and most of them will be using hedging tools of their own. The most popular ones are portfolio construction, options, and volatility indicators.
Modern portfolio theory (MPT) involves using diversification strategies to limit volatility within your portfolio. Taking advantage of expert advice, you can construct a well-balanced portfolio according to your risk tolerance. In this hedging strategy, different assets and asset classes are juxtaposed to create an optimal level of volatility. The relationship of the various assets to each other is also considered.
Using statistics, MPT tries to optimize for the maximum return for the agreed risk level. However, it’s essential to understand that return is always dependent on risk, and therefore risk cannot be eliminated. This method of portfolio construction uses diversification as its primary defense against significant losses so that if one asset loses value, another will gain value or at least remain steady.
To further protect your assets against significant losses, it’s also possible to purchase options that quite literally allow you to hedge your bets. A Put Option is an option in a contract that gives the security buyer the right (but not the obligation) to sell the security (or a specified amount of it) at an agreed price within an agreed time frame. The agreed price is known as the strike price.
A Call Option is similar but gives the right to buy rather than to sell the security. Taking out an option on a security protects the investor against a steep loss of value, as they can cut their losses by selling it at the strike price any time up to the option expiry date.
However, the put option is, in a way, a commodity increasing in value as the underlying asset loses value and decreasing in value as the underlying asset gains. It’s also worth less the closer you get to the expiry date. Taking out an option on every security in your portfolio would be too expensive to be cost-effective, but you can buy an index option on one of the major financial indexes. A bear put spread is one such strategy that covers a wide range of industries and businesses.
By tracking the Volatility Index Indicator (VIX), investors can keep abreast of potential volatility and protect their portfolios accordingly. The VIX is a measure of implied volatility, based not on the underlying assets but on put and call options on the S&P 500 Index. The VIX is sometimes referred to as the “fear index,” as periods of increased volatility can cause it to spike dramatically.
If the index stays below 20, this indicates low volatility. At 30 or more, the market is highly volatile. Remember that this is volatility across the whole market, not in individual securities. You can purchase exchange-traded funds (ETFs) that track the VIX, and it’s possible to use ETFs or options to go long on the VIX as a volatility-specific hedge.
All these hedging tools and strategies have their advantages and disadvantages. The degree to which you should use them depends on your risk tolerance. In the case of options, you are incurring an additional financial outlay as you are effectively buying insurance on your investments. Portfolio diversification is always recommended, but the level to which you take this strategy is up to you.
Similarly, it is always worth keeping an eye on the Volatility Index Indicator but whether to track it with ETFs is a personal investment decision that must consider many other factors. Hedging tools and strategies give you greater control over your investments and trading decisions and are there to be used as you see fit.