As we said in our book, Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term, an investment is considered hedged if it has a reduced or limit to the downside loss that it can incur. In other words, as the underlying asset declines, the losses slow or stop entirely. This is what we call defensive hedging.
How do you know if you’re hedged? Ask yourself, do my losses start to shrink as my investment goes against me. Or better yet do my losses stop regardless how bad a stock moves against me.
For the Buy and Hedger’s out there, you know that the risk metric we talk about the most is Capital at Risk (CaR). While this is a term we developed at Buy and Hedge, the concept has been around for a while. CaR is the mathematical amount a position can lose. This is the figure you have to be comfortable with losing if an investment goes the belly-up.
For an un-hedged long stock position CaR is around 100% because mathematically, a stock can go to zero and you lose 100% of the investment. This happens more often that you may think. Just ask one-time giants like American Airlines or Eastman Kodak. Its true that they may not all happen overnight like MF Global, but it happens nonetheless.
This is why we created Rule #1: Hedge Every Investment.
It is often said that options are risky investments, and that can be true. However, it is less frequently said, but even more true that Options are the single most versatile instrument for defining risk and protection.
We like to use options to create these hedges for 3 reasons:
- Options can create a nearly 100% correlation to the underlying stock so investors can mathematically define where their losses are capped
- Options are an effective use of cash. Because of the leverage they bring to the table, they will allow a hedge to be set without having to give up a whole lot of buying power
- Options can self-fund. Selling away stock performance you never planned on participating in in the first place, can help pay for the protection you hedge with.
One simple way to hedge is to buy a put on a long stock position we call this a married put. If the puts are expensive you can sell calls to create what is termed as a collar. Those are exmamples of hedges for long stock positions.
What many first time hedgers forget is that just using covered calls does NOT create hedged positions. This is because Capital at Risk is still 95-98%. If the stock has a dramatic drop, then the call does very little to slow the losses. It is true that the income generated from the call is retained, but that is usually a small pittance compared to the much larger loss the stock can take.
I’d like to remind everyone to be sure to always go back to knowing your risk to tell if you’re properly hedged or not. That's why Rule #2: Know Your Risk Metrics was created.