Stock Hedging Strategies
If you are concerned about shorter-term losses, there are two primary ways to hedge the stocks in your portfolio.
Stop-loss, stop-limit, and trailing stop orders are designed to limit a person’s loss on a stock or exchange-traded fund (ETF). They do not work on traditional mutual funds.
A stop-loss order is simply an instruction to sell a stock or ETF when it reaches a certain price. When the designated price is hit, the order gets filled at the next available price (market order). Let’s say SPY (SPDR S&P 500 Index ETF) is currently trading at $250 and you place a stop-loss market order at $225 to protect your downside. Under normal conditions, you wouldn’t be guaranteed a price of $225, but you’d probably get very close. However, in a rapidly dropping market, the execution price could be several dollars less.
A stop-limit order is similar to a stop-loss order, but it will only be executed at a specified price or better after the initial stop price is reached. There are two prices involved, a stop price and a limit price. Using the example above, if SPY hits $225, and your limit price is also $225, then the sale will only occur if it can be sold at $225 or better. In a rapidly dropping market, that may not be the case. You might not get to sell at $225 and your investment could keep losing value. The way around that is to use a slightly lower limit price, say $223. That way, if SPY drops to $225, the limit order of $223 is triggered and, under normal market conditions, you should get $223 or better.
It is important to keep a watchful eye on stop orders. Stop-loss and stop-limit orders should be occasionally adjusted. If SPY grows from $250 to $300 over the next few months, you may want to increase your stop loss from $225 to $275. A third type of stop order, called a trailing-stop, can do this automatically. With a trailing-stop order you can designate a certain percentage or dollar amount that the investment would lose before it is sold. This amount is calculated on the investment’s high price, so it is constantly adjusting. If you place a 10% trailing-stop on SPY when it is trading at $250, it will trigger a market order if SPY hits $225 (a loss of 10% from its high point assuming that it never went higher than $250). However, if SPY grows to $300, the trailing stop will automatically adjust to sell if SPY hits $270 (a 10% loss from $300). While it’s nice to have an automatic price adjustment on the stop order, it does lack a limit price. So like with a stop-loss, it just triggers a market order and there is no guarantee of actually getting $270 or higher.
Stop orders can be put in place for a period of up to 6 months. At that point, they expire and new stop orders entered. There are several things to keep in mind with stop orders:
- While they do increase the likelihood of selling at certain prices, there are no guarantees.
- They can certainly limit your loss in an investment, but they can also limit your gains as well. If an investment hits the stop price briefly and then rises again, a trade execution (sell) would mean you miss that price increase.
- Automatic execution may trigger unwanted capital gains in taxable accounts, thus adding to your taxes.
- It is also important to have a plan for post-execution. The stop order worked, you have your cash – now what? Do you wait for the market to drop lower before going back in? What if the market starts to increase again? There’s always uncertainty in the market. Before using stop orders, we like to have a game-plan in place so we know what our next move will be.
Hedging funds are not “hedge funds”. They are usually designed to return the inverse of a certain index, like the S&P 500 (large caps), Russell 2000 (small caps), MSCI EAFA (international developed markets), or certain sectors like real estate, financials, or health care. If the index is down 5%, the fund should deliver close to a +5% return.
Hedging funds are usually not designed to be held long-term. An investor might use them if they felt the short-term outlook for the market was negative, but still believed the market would be higher in a few years. A hedging fund would allow that investor to not sell their core holdings (which could create tax consequences) and still hedge their portfolio against a loss. These funds tend to run on the expensive side and are rarely used, especially with the onset of defined outcome funds.