diversification strategies hedging and collaring

Diversification Strategies to Know: Hedging & Collaring

by Joshua Swartz

Market crashes happen, and investing in the stock market involves risk. Diversification is one way to mitigate risk in a portfolio — and hedging and collaring are key diversification strategies to know when building an investment plan that adequately balances risk and reward. Hedging is a strategy that can help reduce your risk and is designed to protect against large losses by taking an opposite position in a related asset. Collaring is yet another strategy that can limit large losses, but also limits large gains. Hedging and collaring can be very important tools in your long-term, custom diversified portfolio.

Historically speaking, equities tend to do well when the overall economy is doing well. Bonds tend to provide some protection and perform better when the economy isn’t as robust. This is one of the key driving factors why many believe they should be used together in a well-diversified portfolio. Hedging and collaring can be used together or separately to offer even more strategic protection, in today’s environment of historically low interest rates as well as unprecedented monetary policy.

What Is a Hedge Investment?

A hedge is an investment intended to move in the opposite direction of another asset in your portfolio — a good hedge gives you inverse exposure. If your at-risk investment declines in value, your hedge should be designed to increase in value, thereby offsetting potential losses in your portfolio. Effective hedging is flexible. Applied broadly, it can minimize losses across an entire asset class within your portfolio. This can act as a shield when individual sectors or stocks suffer declines. As always, smart hedge investment strategies should be customized to your specific needs, goals and risk tolerance.

The Perfect Hedge

If you get your hedge just right and it completely offsets your loss in one investment with gains in another, it’s called the “perfect hedge.” 

For example, let’s assume the current spot market price for crude oil is $60 per barrel. A crude oil producer is planning to sell 500,000 barrels of crude oil in the cash market in December. Because they’re “long” the commodity, spot market prices are more volatile than the futures price and the producer is subject to price risk until December.

In order to hedge the December price against price fluctuations, the crude oil producer has to take a short position (the opposite of the physical position) in the financial market and sell 500 December crude oil contracts. Assume the current NYMEX December futures market price is $61.00. When the hedger has the long position in the spot market and the short position in the financial market, it’s called a “seller’s hedge” or “short hedge.” In this case, the price is now set at $61 for December delivery. If the price of a barrel of oil goes down to $59.30, the December futures contract would be $60.30 per barrel, creating an example of a perfect hedge.

Collar Option Strategy

Collar option strategies are typically employed when you want to attempt to limit risk or protect a previously purchased asset. A collar is created by owning stock and at the same time buying protective puts and selling covered calls on a 1-to-1 basis. These can be a form of “portfolio insurance” because the calls and/or puts are “out of the money,” meaning that they only contain extrinsic value. OTM call options will have a strike price that is higher than the market value of the underlying asset, while OTM put options will have a strike price that is lower than that of the underlying asset.

Let’s say you own 100 shares of XYZ stock. You would need to buy one out-of-the-money put and sell one out-of-the-money call to create the collar:

  • If you own 100 shares of XYZ stock at $100, then
  • Buy 1 contract (100 shares) of XYZ $95 put at $1.60 and
  • Sell 1 contract (100 shares) of XYZ $105 call at $1.80

This collar strategy is also known as a “hedge wrapper.” If the asset price declines, then your put provides protection until the expiration date. If the stock rises, your profit potential is limited to the upper strike price of the covered call less commissions.

Hedging Is Like Fire Insurance

Robust diversified portfolio construction includes hedging strategies for specific downturns. Most well-diversified portfolios include a variety of stocks, bonds and commodities. Using options to hedge your portfolio when implied volatility is elevated is generally expensive. The key factors to consider when setting up a viable hedge is cost and effectiveness. Investors considering any portfolio hedge should have strong experience using options contracts or work with their trusted advisor to assess the viability for their portfolio goals.

Portfolio hedging can become part of your long-term investment strategy. Its flexibility allows you to apply it or remove it as necessary, without interrupting your core strategy. Like fire insurance, it can provide short-term protection from adverse or severe market events. It does cost money to deploy this protection; however, it is extremely useful when the market declines. This strategy can also give investors added benefits such as:

  • Providing you an alternative to selling in a down market,
  • Preventing you from realizing investment losses,
  • Preventing redemption fees and transaction costs, and
  • Preventing potential negative tax consequences.

Lower Risks, Limited Rewards

Useful hedging and collar techniques are purpose-built. Similar to the concept of diversified portfolios, the primary directive with these strategies is to mitigate risk rather than maximize return characteristics. Hedging and collar option strategies again act like insurance by limiting downside risk, but at a cost. The Nobel Laureates in Economic Sciences, Amos Tversky and Daniel Kahneman, said, “One of the basic phenomena of choice under both risk and uncertainty is that losses loom larger than gains.”

It generally takes much longer to realize market appreciation versus sharper, quicker market crashes. Therefore, long-term portfolios and those with short-term time horizons can benefit from careful risk mitigation. Hedging can be very appropriate during times of high volatility in the markets or if a specific asset price has moved up substantially and you believe it might correct over the short term. You may even consider “tail risk” hedging where during uncertain times, you invest a specific amount of capital in exchange for potentially large gains if the market sharply plunges as it did in the first quarter of 2020. 

Custom hedging strategies are very useful within your diversified portfolio. However, it’s important you fully understand the strategy and its potential drawbacks. Contact us for more in-depth information or to set up a consultation with a registered wealth advisor.

Sources:

Hedging – Definition, How It Works and Examples of Strategies (corporatefinanceinstitute.com)

Collar – Investopedia

Perfect Hedge | EBF 301: Global Finance for the Earth, Energy, and Materials Industries (psu.edu)

Perfect Hedge – Definition – The Business Professor, LLC

Collar Options Strategy | Collar Options – The Options Playbook

EconPapers: Advances in Prospect Theory: Cumulative Representation of Uncertainty (repec.org)

Psychologist wins Nobel Prize (apa.org)