This Market Is Trickier Than You Think. How to Hedge.

Traders at the New York Stock Exchange on Nov. 10. (Michael Nagle/Bloomberg)

Modest stock declines tend to make investors—and many pundits—fret that a catastrophic decline is about to pummel the market.

It is a reflex that often arises after stocks have exhibited great vigor, or when a strong corporate earnings reporting season is nearing an end.

The absence of event-driven trading creates a news vacuum and tends to make many investors forget that stocks often decline after strong rallies. In addition, many investors calibrate their outlooks during earnings season to reflect companies’ guidance, which affects short-term market tempos.

Investor sentiment is primitive. For most investors, the market is either good or bad. That’s why a little weakness can be counted upon to spark interest in hedging a stock portfolio. Yet many investors lose money when hedging because they have no idea how to handle the strategy.

Though the stock market has begun to show bullish signs on the resolution of the federal government shutdown, the interest in hedging is unlikely to moderate without a definitive resumption of the rally.

Our preferred strategy remains selling put options on blue-chip stocks during declines, which allows investors to buy quality stocks at lower prices. But many investors instead buy puts with a strike price that is at, or just below, the market price. The trade makes them feel good, as they reason they have protected their unrealized gains—even though such options are often priced in ways that require Armageddon to occur for them to prove profitable.

For investors who are contemplating hedging, we offer a better alternative:

1. Determine the stock market decline that you can withstand. A 10% decline should be easy to handle, but some investors draw the line at 5%. Use whatever level you choose to help set the hedge strike prices.

2. Never buy a single put. Instead, use a put spread—which entails buying one put and selling another with a lower strike price and similar expiration. The spread increases in value if the associated security declines from the upper strike to the lower strike. The strategy lowers hedging costs because a put was sold against one that was bought. The payout can be lower than when you buy a single put, but the gains can still be substantial.

3. Monitor the hedge and make a plan to take profits. If the hedge increases in value by, say, 50%, cash out and close the spread, or reset the hedge to reflect new market levels. Many investors lose money on hedges because they fail to take profits. Should a decline occur, they become captivated by the carnage and believe a bigger decline is coming.

Let’s illustrate the strategy with the S&P 500 SPDR exchange-traded fund (ticker: SPY). With the ETF at $683, buy the January $660 put and sell the January $640 put. The spread costs about $3.50, and it is worth a maximum profit of $16.50 if the ETF is at or below $640 at expiration.

If the ETF is above the $660 put strike at expiration, the hedge fails.

As always, there is some hedging evident in the market, but it isn’t widespread. Hedging portfolios, and trying to profit from short-term declines, has been difficult for a long time.

The stock market has recovered from so many difficulties that some sophisticated investors view hedging as tantamount to burning money. They have bought hedges and stocks have rallied, rendering the trade worthless.

The skepticism over hedging will inevitably be challenged in the worst way, though when that occurs is impossible to know. For those who feel compelled to hedge now, these simple guidelines offer a way to implement the strategy without being the options market’s fool.

Email: editors@barrons.com