Hedging for volatility (27Apr2023)

 What is hedging?

Fidelity defines the following hedging:

Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.

Investopedia has the following definition:

Hedging techniques generally involve the use of financial instruments known as derivatives. Two of the most common derivatives are options and futures. With derivatives, you can develop trading strategies where a loss in one investment is offset by a gain in a derivative.

Magolorean states the following as common hedging strategies:

There are three common hedging strategies: diversification, options trading, and futures contracts. Each strategy has its own advantages and disadvantages depending on your individual needs and goals as an investor

(Below are some suggestions about hedging when I asked ChatGPT.)

1. Diversification: One of the simplest and most effective ways to hedge a portfolio is through diversification. By investing in a variety of different asset classes and securities, you can reduce the overall risk of your portfolio. This is because different assets tend to perform differently in different market conditions, so having a diversified portfolio can help mitigate the impact of market downturns.

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3. Options: Options are financial instruments that give you the right, but not the obligation, to buy or sell a security at a predetermined price within a specific time frame. Options can be used to protect your portfolio against market downturns, as well as to generate income.

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5. Futures: Futures are contracts that obligate you to buy or sell an underlying asset at a predetermined price on a specific date. Similar to options, futures can be used to hedge against market downturns or to generate income.

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7. Short Selling: Short selling involves borrowing shares of a stock and selling them in the market, with the intention of buying them back at a lower price to make a profit. Short selling can be used to hedge against declines in the market, but it can also be risky and should be done with caution.

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9. Hedge Funds: Hedge funds are investment vehicles that use a variety of strategies to generate returns, including hedging against market downturns. However, hedge funds can be complex and require a high level of expertise to invest in.

It's important to note that each of these hedging strategies has its own risks and limitations, and should be carefully considered before implementing them in a portfolio.

My investing muse

My current investing approach takes in the following considerations:

1. Macro factors (not limited to considerations of GDP, inflation & unemployment) ~ currently, I am monitoring the trade volume, household debts, commercial real estate and the banking sector that continue to waver.

2. Business fundamentals ~ I do these from the study of business financial statements, earnings reports, and business moats with the intent to identify great companies that can create great value and great returns subsequently. These incorporate a mix of quantitative and qualitative factors. For financials, I look for increasing revenue, increasing net profit, improving Free Cash Flow (FCF) and increasing net assets (ie total assets less total liabilities) as a macro filter.

3. Technical analysis for entry and exits. My setup is simple, relying largely on MACD indicator referencing 1D (or longer charts).

1D chart of $UVXY

Personally, I do not trade options, crypto or futures and thus, I have limited options coming to hedging. For me, I rely largely on diversification and buying inverse ETFs (in anticipation of a market downturn).

Diversification

Coming to diversification, I am doing across different countries/regions, asset classes and securities. I started years back with 100% in US equities. Over time, I am building up a portfolio that is Asia-centric, intending to accumulate equities of over 50% for this region. I am also researching BRICS & BRICS+ which represent about 48% of the total world population. Currently, China/Hong Kong holds most of my Asian equities but I intend to wind down my holdings from 2035 in anticipation of population decline.

Apart from equities, I have also invested in real estate in different countries. Real estate remains the one with the best returns.

Inverse ETFs

In anticipation of a market downturn, I have chosen to buy inverse ETFs that benefit from a market downturn. After some research, these are cheaper and offer lesser risks compared to shorting companies.

What other assets are good for hedging

There are several asset classes that can be good for hedging an investment portfolio:

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2. Fixed Income Securities: Government bonds, corporate bonds, and other fixed-income securities can provide a hedge against equity market volatility. During times of economic uncertainty, investors tend to flock to safe-haven assets such as bonds, which can help to offset losses in other parts of the portfolio.

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4. Gold and Precious Metals: Gold and other precious metals are often used as a hedge against inflation and currency devaluation. They have historically held their value during times of economic uncertainty and can provide a diversification benefit to an investment portfolio.

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6. Real Estate: Real estate can provide a hedge against inflation and can generate income through rental yields. Real estate investment trusts (REITs) are a popular way for investors to gain exposure to the real estate market.

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8. Alternative Investments: Alternative investments such as hedge funds, private equity, and venture capital can provide diversification benefits and non-correlated returns to traditional asset classes.

It's important to note that not all asset classes are suitable for all investors, and the best hedging strategy will depend on individual goals, risk tolerance, and investment time horizon. It's always advisable to consult with a financial advisor before making any investment decisions.

I recommend doing our research as our investing need to fit our circle of competence, time horizon, risk/reward ratio and investing strategy. My inverse ETF would take time to realize the profits but there are various signs of an approaching recession. Currently, I am not adding any positions for my shortlisted stocks and I am largely trading inverse ETFs. I wish that I am wrong but we should expect “blood on the street” for a crash that could rival 1929.