A hedge is an investment to reduce the risk of adverse price movements in an asset.
Let me outline some common hedges below:
- Cash hedge
By far one of the most common strategies. Here we keep a certain allocation of assets as cash. There are several methods to determine the percentage to keep such as constant or dynamic. For an introduction to some of the assets allocation strategy, you can refer here. The hedging cost here is at no cost but you would see a drop in net assets at a crash or correction. The excess cash will be the firepower to buy undervalued assets.
- Buying of put options/Collar
This comes at a cost. But your portfolio can be protected. The downside is when the market is moving sideways, you will suffer a loss. Alternatively, you can set up a collar trade which is selling a call to buy a put option. The downside for this is your gains are limited when the market is very bullish. For more on it, you can refer to here.
In regards to which counter or ticker to set up, you can consider using either your stock holdings or ETFs. For stock holdings that are not optionable, ETF is one of the easiest choices. Personally, for US, I prefer using QQQ or SPY. For SG stocks, EWS, since SGX stocks are not optionable.
- Back Ratio
Another popular option strategies for a hedge is back ratio. Here we sell 2 puts and buy 1 put at a higher strike price. The premium collected from the 2 short puts are used to offset the cost the put. The cost is usually zero. However, the hedge is ineffective if the market crash badly.
For example, you sell 2 QQQ puts at strike 120 to buy a put at strike 130.
Currently, QQQ could be trading at 140. You will have the maximum profit if it drops to 120. If it drops to 110, you break even. Anything more than that, you will be losing money.
- Short ETF
There are some inverse ETFs that rises as the market goes down. Timing is important and there are some transaction costs and it’s not fully covered. There are also double or ultra short ETFs that double or more when the market goes down. In a bull market, all your short ETF will suffer in value. Do note that many of the ETFs have decay factor due to the cost of contango.
- Volatility play
In a crash, the volatility is high. One possible play would be having a position in VIX related ETFs to hedge against it. Some common instruments are VXX, VIXY, SVXY. You can use multiple option strategies on these instruments.
- Long/Short Strategy
This is the most common hedge fund strategy. It involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value. The long/short pair are usually highly correlated and in the same industry. If implemented well, it offers nice risk-adjusted returns. An alternative, you can also buy a long call/put option pair of two related equities.