Trading Rule – “When in doubt protect your portfolio…”

WHAT DO WE UNDERSTAND BY PROTECTING THE PORTFOLIO? IT ESSENTIALLY REFERS TO THE HEDGING OF YOUR RISK IN THE PORTFOLIO. THE DECISION TO PROTECT THE PORTFOLIO HAS TO BE TAKEN CAREFULLY BECAUSE IT HAS TWO IMPORTANT IMPLICATIONS. FIRSTLY, HEDGING HAS A COST AND THAT IS A KIND OF SUNK COST THAT REDUCES YOUR PORTFOLIO ROI. SECONDLY, HEDGING ALSO PUTS A CAP ON THE RETURNS ON YOUR PORTFOLIO BEING THE PRICE FOR REDUCING RISK ON THE DOWNSIDE. WHAT IS MORE IMPORTANT IS WHEN SHOULD YOU HEDGE YOUR PORTFOLIO AND HOW!

HEDGING YOUR PORTFOLIO THROUGH DIVERSIFICATION

This is the simplest form of hedging your portfolio. What diversification means is that you spread your risk across more assets with focus on dissimilar assets. For example, if you are holding banking stocks then adding more banking stocks beyond a point only adds to the risk. Secondly, you also need to diversify across themes. For example, IT and pharma may be fundamentally different sectors but both react negatively to dollar weakness. That is the common theme in these two sectors and hence you need to manage your exposure to these two sectors when the INR is strengthening. You must know that diversification has a numerical limit. It works up to 10-12 stocks. Beyond that, it only substitutes risk!

HEDGING YOUR PORTFOLIO THROUGH OPTION HYBRIDS

Options, unlike futures, are not linear products as their payoffs are not linear. For example, when you buy a call option or a put option, then your losses will be limited to the option premium but your profits can be unlimited after you cover the hedging cost. Thus, if you attach a lower strike put option to your equity stock then you are profitable on the upside once the cost of the put is covered. On the downside you are only risking till the time you are able to break even the put. Another way of hedging your risk is to convert your equity or your futures position into a call option position. Hedging can also be done to reduce your cost of holding a position. For example, if you have bought a stock at higher levels and the price is down, you can consistently keep selling higher calls to ensure that your average cost of holding is reduced. The big question is when to opt for hedging?

“The purpose of hedging is not about being right or wrong on the direction. It is when you are not sure of the direction of the market” – Anon

6 TRIGGERS FOR YOU TO SEEK PROTECTION ON YOUR PORTFOLIO…

  1. When the macros are presenting an uncertain picture, it is best to hedge at a macro level. What do we mean by hedging at a macro level? You can best manage macro risks by buying put options on the Nifty rather than on individual stocks. This may not be perfect but captures the systematic risk in your portfolio quite perfectly. The Nifty options are also substantially liquid and trade with narrow spreads.
  2. An important trigger for seeking protecting for your portfolio is when the volatility index (VIX) moves up sharply. Over the last few months we have seen the VIX stay around the 12-14 mark. Normally markets do not correct too sharply when the VIX is around these levels. It is only when the VIX crosses the 20 marks with a lot of volumes that you run the real risk of the markets correcting. That is the time to seriously seek protection through the hedging process.
  3. When an industry you are exposed to is predominantly seeming to be at risk. We can also include the concept of themes here. For example, rising interest rates are negative for banks, autos, two-wheeler and for realty stocks. Similarly falling rural incomes is bad for fertilizers, entry level cars, two-wheeler, consumer goods etc. These are fairly large definitions and you need to bring on your portfolio hedge accordingly.
  4. When flows, especially institutional flows, are clearly shifting. Normally flows tend to be a function of the valuations in the market. But policy changes can also make a difference. For example, FIIs can get negative when global interest rates are likely to go up. Similarly, domestic investors can get negative when retail flows into mutual funds start faltering. Fund flows tend to have a sharp impact on the market and it is also a better bet to hedge against such risks.
  5. When valuations are looking stretched, it is a good time to get protection. It is very likely that individual stocks may touch ridiculous valuations and continue there. However, the market is an approximation and cannot sustain high valuations for too long. In fact, historic ranges can be quite instructive and you can use them as broad indicators of when to hedge your portfolio and when not to.
  6. When the global and domestic economy are up against uncertain situations, it is a good time to hedge. This could be economic, political, geopolitical, strategic etc. For example, war in West Asia could have negative repercussions for all countries just as a slowdown in China. In such situations, whenever you are in doubt, it is best to hedge.

WHEN IN DOUBT, JUST HEDGE

This is a very important rule for investors and also for traders. There are a lot of domestic and global news flows that can infuse uncertainty into your portfolio strategy. When in doubt, you must seek protection. It may cost and you need to be clear that the cost is justified in the long run. After all, it is better to be safe than to be sorry!

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