Why Hedge When You Could Sell?

Back in late July, a subscriber asked me why hedge instead of selling? So I thought I’d write a brief post answering.

You are not wrong to believe in a trade and still be uncomfortable with the risk of holding it. The company might remain attractive while its shares become vulnerable to a factor shock or broader market dip.

A portfolio constructed with a five-year view might face a difficult quarter, and selling is one response, and often the best. If the earnings case were to deteriorate, the valuation no longer offers much upside, or the position is simply too large, cut it. But suppose the companies are delivering - cash generation might be improving, the numbers support your view, and you still like the prospective returns. Meanwhile, positioning looks crowded, and you’re less comfortable with markets as a whole, given how frothy they look. This doesn’t necessarily mean that every company in your book deserves a smaller allocation.

You may have a better view on those companies than you do on the S&P next month. Yet selling across the book gives up some of the company exposure to act on the market view. It’s something that deserves more thought than it usually gets. In my opinion, being nervous about the index isn’t by itself a particularly great reason to abandon the investments that you expect to do well.

Take a simplified $1m book of single names, against which you short $1m of a suitable index. The index falls 15%, while the companies you hold fall 8%. The shares lose $80k and the short makes $150k, the combined position makes $70k before costs. Selling half would have left you with a $40k loss on the remaining shares, and selling everything would have obviously left you in cash. You made money because the companies did better than the index and they didn’t even go up.

You still want to own those companies relative to the wider market. Selling them removes that opportunity. Keeping them alongside the short allows the stock selection to contribute, although it can just as easily hurt you if the names underperform. The equal amounts are only for example. In practice, sizing would reflect the book’s estimated sensitivity to index. You also need to think about what you actually own. Shorting the S&P against a concentrated collection of speculative software names leaves plenty that could go wrong. A low net exposure can still conceal an enormous amount of risk, as anyone who has watched their longs fall while their shorts rally will know…

Before you choose a hedge, look at what would hurt the holdings together. Ten different names can still amount to one trade (the current market is the perfect example of this). You may well think that you have ten perfectly respectable bull cases but rather less diversification than you had originally thought. The hedge needs to address the exposure causing concern and buying whatever put looks cheap doesn’t tell you whether you have done that.

People talk about drawdowns as though everyone can sit through them, provided they have sufficient conviction. Well… sometimes they can’t. A fund gets redemptions and sometimes risk might force the PM to reduce positions. In a PA, it might be leverage or money that needs to come out. Your five-year view can be perfectly intact while your ability to hold the investment disappears, which is an expensive position to find yourself in. You are selling because you have to, potentially at prices where the potential return has improved.

A hedge can be worth carrying because it reduces the chance of reaching that point. You may still expect the portfolio to make money. Even if I think a sell-off is unlikely, I need to know whether I could hold the book through it. Which also changes how much protection makes sense. If you can carry an ordinary pullback comfortably, there may be little reason to pay to eliminate it. The concern might be the larger loss that would force a change in the book. So start with that problem. There is no particular virtue in spending money to make every week look less volatile.

Cash can provide that breathing room too. The reason to hedge instead is that the exposure you retain is valuable enough to justify the cost. An index short gives up market gains as well as offsetting declines. A put on a single name lets you retain the upside, less its premium, while limiting losses below the chosen strike during its life. Do you want to keep the upside enough to pay that premium?

I think that price is something that tends to disappear from the conversation once everyone agrees the outlook is worrying. A perfectly sensible concern can produce a poor trade. If protection is expensive, hedging may consume too much of the return you expect from the shares. If the shares have already fallen substantially then selling them may mean surrendering a more attractive investment than the one you owned before the decline. Both prices have changed and you have to look at them together, rather than assuming more anxiety means you should buy more protection.

Equally, the fact a hedge loses money doesn’t establish that buying it was a mistake. If your book rallies and the protection expires, you’ve paid for an outcome you were happy not to experience. What matters is whether the cost was sensible beforehand and whether you can afford to keep paying it. For me, this is where discipline comes in. If you’re worried about the next quarter, decide what you’re prepared to spend getting through it and what would make you take the hedge off.

Another key point is to think about what you intend to do if the hedge works, preferably before everyone starts shouting about buying hedges. If the purpose was to help fund purchases after a dip, there should be some kind of view on which prices would make those purchases attractive. If it was to meet withdrawals without selling your longs, the proceeds need to be available when those withdrawals arrive. If I’m relying on profits from puts to fund purchases, I need to decide when to take some money off the table. Taking profit reduces the protection left, so that decision belongs alongside what you are doing with the rest of your port.

Try looking at it from cash. Allowing for costs, would you buy these shares and put this hedge on today, at these prices?

If you would, there’s a case for keeping the trade. If you wouldn’t, I’d be asking why owning it already changes your mind.

For me, the reason to hedge is that I still want those companies in my book. I’m willing to give up some return to reduce the risk I’m carrying, provided the cost of that protection makes sense.

Have a great weekend,

Fed