How to Hedge Your Investment Portfolio Against Market Uncertainty

As we know in today's everchanging world, anything from a political tweet to a global war can come out of left field to send markets into a frenzy! Along with the growing volume of retail investors & day traders, volatility is inevitable and impossible to avoid. No matter how diversified across asset classes you are, a hard hit to consumer confidence & momentum can lead to major losses across the board. Sure, maybe bonds & commodities show some gains when equities are down, but most portfolio styles are not positioned heavily enough in those categories to feel the gain overall.

Think of a hedge like a form of insurance for your investment portfolio. Having insurance protects us from the unlikely circumstances of a major loss/destruction of our valuables & ourselves. We pay a non-refundable monthly premium regardless of whether we're careful or not, but in the event that something bad does happen, that insurance will certainly pay off!

First, I need to point out some major key differences between hedges. A hedge is essentially taking an "opposing" position in order to reduce risk in one's portfolio. There are different ways one could hedge a portfolio, depending on how much opposition the investor wants to tack on. Diversification across asset classes is a hedge in & of itself, however it may not be as impactful as the more direct ways to hedge. A pure play hedge would be taking the inverse position of a fund you're already long in. Ways to do this could be taking a short position or adding put options to your existing shares but just know that these come with a cost (just like insurance). Shorting a position holds extreme risk on its own, as it has infinite downside potential as a shorted security. Thankfully there are more modern approaches to this strategy that I will focus on.

Finding the partridge in the "pair" trade

Today, ETFs are being issued that track the inverse of its underlying index while still considered a long position. This is good in that it does NOT hold the infinite downside potential of a shorted security, and it can be held as a separate tradable position. I like to think of this as a pair trade because they operate like a see-saw.

Inverse ETFs are available for those looking to take some risk off of a large position heavily weighted in that index. For example, PSQ, a ticker symbol issued by Proshares tracking the inverse of the Nasdaq-100, could be considered in a portfolio where an investor holds a large quantity of shares in QQQ which is the Invesco Nasdaq-100 ETF. Why not just sell shares of QQQ to take risk off the table, you ask? Well, some investors prefer to build upon their current positions or simply create opportunities to realize gains from the inverse ETF when the QQQ goes down. When QQQ goes up, PSQ goes down in the same fashion, and vice versa. Additionally, there are riskier ETFs with leverage amplifying its upside or downside. Similar to the above strategy, SQQQ is the 3x leveraged inverse ETF that opposes the Nasdaq-100, where TQQQ is the 3x leveraged ETF that tracks the same index. So, when TQQQ goes up (at 3x the rate), SQQQ goes down (at 3x the rate), and vice versa.

Using the "hidden gem" index to your advantage

The Volatility Index (VIX) is an index that measures the "expected" uncertainty in markets based on short-term price fluctuations compared to the S&P 500. It's important to point out that the VIX is not an inverse correlation to its underlying index, but rather rises upon higher uncertainty. A low price on the VIX (typically below 20) represents stability and certainty usually when fear is low. A high price on the VIX (typically above 30) represents greater investor uncertainty/fear.

The beauty of tracking/trading the VIX is that it's an independent index that covers broad-based uncertainty rather than a selective index. Personally, from my experience I have found that trading ETFs that mimick the VIX index have sat more comfortably in my portfolio overtime with much less maintenance required. Some examples of these ETFs are VIXY & UVXY (3X leveraged) that can be bought & sold on the exchanges.

What's my secret recipe to building a hedge position?

Hedging is not a strategy for new or beginning investors/traders but rather should used by experienced investors in a healthy balance without making any rash decisions on either end of the see-saw. It's easy to get carried away when markets are doing good and the outlook is positive, but that is exactly when one should become skeptical and start adding shares of their preferred hedge to protect themselves at a discounted price. Remember, while everything is rainbows & butterflies in the market, hedge products are typically traded at a lower price during that time.

It's like buying clothes for the winter while its summertime. Usually, nobody is thinking about heavy warm clothes while it's hot outside, so merchants likely offer discounts to those who shop early. The ones who shop during prime time will often pay the premium price due to the high demand.

Buy low, sell high. I always buy my shares in small increments as it comes down in price to prevent spending more money on higher costing shares. That way, as the price continues to drop I can average my cost basis down. Ultimately, when the price heads back up, I sell shares on a lot selection basis to remove the shares purchased at higher prices and hold onto those that I purchased cheaper. Psychologically, it is more encouraging to hang onto shares that have an unrealized gain rather than a loss. By fending off my unwanted shares, it gives me more buying room for a better opportunity or the ability to wait for an even lower price than my current cost basis.

When to have & when not to hold. At any given time, being tactical and actively grooming a portfolio can give an investor a major advantage based on where markets are trading. Ask yourself, would you rather be overweight a hedge position when the underlying index is trading higher or lower? The answer should be when the market is trading higher because the probability of a short-term correction is higher, and you'd want to be prepared for the hedge position to move up in price when the market falls lower. Ultimately, you're left with a larger position of the hedge compared to when you started buying it. On the contrary, when markets are trading lower, that is when your hedge position will be trading at higher prices. Therefore, it's probably a good time to ward off your higher priced shares of the hedge in the likelihood of the overall market rising after being oversold. This is when you would rather be underweight a hedge position in comparison to when you started adding to it.

Dont chicken out! Maintain a bare minimum position of your hedge at all times if you plan to hedge. I can not stress this enough! Some of the biggest mistakes I've ever made trading were from trying to call the tops on both sides of the see-saw with a hedge. The worst thing is having underestimated a market downfall and you're all sold out of your hedge position that you had at lower price! You may miss out on a huge short-term opportunity to sell some shares at a parabolic price, and the last thing you would want to do is have to buy back in at a regretful price. That is exactly why my strategy of buying in gradual increments and selling in increments has worked best for me.

I know that was a lot of confusing information jumbled into a few paragraphs, but I promise to only share the strategies that have worked time after time for me in my years of experience and help prevent mistakes I've made myself. Thank you for taking the time to follow my journey!

Until next time,

XO Hope