Through the last several posts we’ve reviewed covered some different ways to hedge positions in stocks and other investments. This included:
1) Selling short companies in the same industry or other industries that one would expect to fall along with the industry in which the investor is long: https://smallivy.wordpress.com/2010/06/07/hedging-a-stock-position-using-short-sales-protecting-a-portfolio-in-a-bear-market/
2) Buying put options on the shares: https://smallivy.wordpress.com/2010/06/18/how-to-hedge-a-stock-position-using-put-options/
and 3) Selling covered calls, which produces income and provides somewhat of a hedge since the income from the call writing offsets some of the losses when the stock price falls: https://smallivy.wordpress.com/2010/06/13/covered-call-writing-how-to-make-most-any-stock-pay-a-dividend/
While each of these strategies will provide a hedge, each also has its downfalls. Because stocks can continue to go up for some time even when the market is due or past due for a fall, one may need to cover short positions before the market does finally does capitulate. Things can also happen to individual stocks such as buyouts that cause the shares of your short sale to rocket up, forcing you to cover the position.
Put options expire, and you may end up buying put option after put option, only to see them expire worthless. Then the day that you forget to but a new put is the day the market will fall 10%.
Writing covered calls is a conservative strategy, but what do you do when the stock has fallen by 10%? Do you buy an offsetting call to close out your original position, where the call was written at a much higher strike price, and then write a new call at the lower price? What if the stock then goes up? Do you close out the position, taking a loss, and then write another call, hoping the stock goes down again? Also, what if the stock goes up 10% after you write the first call? Do you close out the position and take a loss on the call you wrote, risking that the stock would then fall?
Perhaps the best strategy for hedging, and the only one suitable for serious investors who are investing to make a great deal of money rather than gain some entertainment, is to simply sell off portions of a position once it becomes large enough to worry about losses. If a position seems particularly pricey, in that it would take several years for earnings to justify the current price, it is best to close out the position. If it looks like the entire market is about to fall, it is probably best to close out some of the positions that have done really well, or at least take some money off of the table, and start pooling up resources to buy after the fall.
One must be careful, however, in that most of the returns of the stock market are due to a few day’s worth of gains. If one is constantly diving into and out of the market, one may miss one of those days, which could mean the difference between making a 15-20% annualized return and 5% return.
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.