Hedging Strategies – Balancing Your Stock or Options Portfolio

Market neutral, delta neutral, or balanced portfolio; call it what you want but the concept of making money regardless of where the stock market goes has been a long-time goal for many traders. But what happens when your portfolio becomes unbalanced? What are the best hedging strategies you can use to get back to a neutral stance?

In today’s show, I'll walk through three different portfolio scenarios and offer my advice on the best hedging strategies to use to help re-balance your positions. You'll hear which options strategies to use if you're too bullish, too bearish or completely lopsided. Plus, I'll help you learn how to hedge stocks that don't have tradable option contracts.

Of course, it all starts with a solid understanding of how to determine what your portfolio looks like on either a beta-weighted or delta-weighted basis. It's enough anymore to just have a couple of bearish trades and a couple of bullish trades. You have to determine what the net impact of each position is in the overall portfolio. If you can do that, you'll be well on your way to consistently generating income with options regardless of the market direction.

And as always, if you've got questions on portfolio management or hedging trades, add them in the comments section below, and I'll make sure to reply personally to every single one.

Key Points from Today's Show:

• A hedge is a counter trade to something else that you are doing. Meaning, if you are trading something long, then a hedge is trading something short.
• A hedge is not meant to always be a one-to-one relationship. It is just the idea that you should be having multiple positions in multiple directions at one time - some bullish, bearish, and neutral positions in your portfolio.
• Have to have an understanding of what your full portfolio looks like on a beta-weighted or delta-weighted basis. Most broker platforms have an overall evaluation method for this.
• Think or Swim list two ways of determining what the beta or delta-weighting of your portfolio is. This is important because you have to look at it on a apples to apple basis.
• As a rule of thumb, use one ETF or benchmark for your entire portfolio - S&P 500. This allows you to have a good frame of reference for how you should adjust or add trades going forward in the future.
• Once you find out where you portfolio is and how it is balanced, you have to figure out if you are lopsided in one direction or another, or on both sides. The goal is always to be as neutral as possible, meaning to have a nice even distribution or normal distribution graph kind of centered over the market.
• Want to avoid the one-directional risk of a single position. This is why you want to add hedging strategies and different trades at all times in your portfolio - don't want all your eggs in one basket.
• The more trades and positions you have on, the less risk you have in your overall account.
• Can use any security to hedge another security, as long as you know how that security reacts to the market. If you can match up two securities, then you can have a well-diversified portfolio.
• Can default to the most liquid security out there with the highest implied volatility because you can factor in the Beta equivalent of that position.

Two Ways to Determine Portfolio Balance

1. Monitor tab, under activities and positions.

• The website does the calculation and shows you what your relative risk is to the market moving up.
• Now you can look at one benchmark, one index, and build everything around that benchmark/index, no matter position or industry you are trading — the goals is to have your delta in a neutral range.

2. Risk profile and analyze tab.

• Type in symbol and analyze position based on a single symbol or portfolio beta weighted basis.
• When Beta weighted to SPY, now your entire portfolio is going to show where you make money based on where the movement of SPY is.

Hedging Scenarios:

1. Portfolio is Too Bullish:

• Here you will make the most amount of money possible if the market moves ups in direction, so you should add some bearish positions to your portfolio to help counterbalance the fact that you are already bullish.
  Examples: put calendar spreads, call credit spreads, or put diagonal spreads.
• Put calendar spreads and put diagonal spreads allows you to profit from market rise in volatility — when market goes down.
• However, if the market is experiencing high volatility and you need to be more bearish, sell call credit spreads that are out of the money and above where the stock or ETF is trading.

2. Portfolio Too Bearish:

• For this scenario, trade naked short puts or short put credit spreads below the market. These are the best strategies to use when you want to gain some bullish exposure and sell high overpriced option premium and volatility.
• Use long call debit spreads, when the market is experiencing low volatility and your portfolio needs some bullish exposure. Best strategy if you need some bullish exposure, regardless of volatility.

3. Portfolio is Too lopsided:

• This scenario rings true when your portfolio has good exposure in the extremes, but nothing in the middle, nothing that profits from the market staying in a range or a defined area.
• You will need to get more neutral with straddles and strangles, iron butterflies, and if there is low volatility you could do some at the money calendar spreads in one direction or another.
• This will help raise the middle curve of your portfolio and allow you to profit from the market staying range-bound.

4. Long stock and getting started:

• A quick way to hedge is by using a cost-less collar (Episode 30). This is a zero-cost way to protect your portfolio from a slight drop in stock price
• Entails buying an at the money put spread and then selling a call to finance that trade for a net credit. It costs no money and reduces your risk in the trade by the credit you receive.

5. No or lightly traded options:

• Not all stocks are optionable, or have liquid options that you'd want to trade. When hedging, you want to go to a related beta or industry or company security in that sector/market.
• Example: if trading Facebook, use Twitter as a relatable stock to hedge that position. If trading Chipotle, use McDonalds to hedge.

Another Hedging Example:

You are trading Microsoft and you don't or can't get into trading another hedge in Microsoft, so you've got to use something else. Microsoft has a Beta of 1 so it will mimic what the S&P 500 will do, more often than not. Can then type in anything — TLT, which has a -0.52 correlation to the market. This means that if you got short TLT by a factor of 2, then you have a -1 hedged and matched up Beta to the Microsoft +1 beta position. Therefore you can use anything in your portfolio to hedge anything else. It's just a matter of finding the most liquid securities.