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With the broad exposure available through exchange-traded funds (ETFs), investors can build portfolios composed entirely of these funds to reach a wide range of objectives. In addition to their versatility across asset classes, index-based ETFs also offer several viable hedging options for investors concerned with economic or market cycle changes and their effects on portfolio holdings. The following are four hedging strategies for index-based ETFs.
Hedging With Inverse ETFs
Investors concerned with short-term risk in long index-based funds or stock positions can incorporate inverse ETFs that appreciate when their tracking indexes fall in value. For example, a long position in the PowerShares QQQ Trust (NASDAQ: QQQ), which tracks the NASDAQ 100 Index, could be hedged with an offsetting position in the ProShares Short QQQ (NYSEARCA: PSQ). With this hedge in place, losses in the PowerShares QQQ Trust are neutralized by gains in the ProShares Short QQQ.
Investors can also hedge stock portfolios with inverse index funds composed of similar holdings. For example, a portfolio of stocks built to track the Standard & Poor’s 500 Index (S&P 500) could be hedged with the ProShares Short S&P 500 ETF (NYSEARCA: SH), which appreciates by the same percentage as the declines on the index.
Hedging With Leveraged Funds
Investors also have the option of hedging with leveraged inverse funds. Adding leverage to an inverse fund multiplies the percentage changes on the index being tracked, which makes these ETFs more volatile but allows for smaller allocations of capital to hedge positions. For example, the capital required to fully hedge long exposure with a nonleveraged fund is equal to the amount invested in the long position.
With leveraged inverse funds, however, the intrinsic volatility results in a lower capital requirement to offset declines. With a fund offering triple leverage, such as the ProShares UltraPro Short QQQ (NASDAQ: SQQQ), the capital required to fully offset changes in an index is approximately 33% of the long position. For example, a 3% decline in a $10,000 position in the PowerShares QQQ Trust results in a loss of $300. In a triple leveraged inverse fund, the percentage loss on the index is multiplied by three for a gain of 9%. A gain of 9% on a $3,300 position is $297, offsetting 99% of the loss. Investors should note that, due to the reset of leverage on a daily basis, the performance of these types of funds is generally more predictable when they are used as short-term trading vehicles.
Writing Options
Investors expecting markets to move sideways for a period of time can sell options against their positions to generate income. Referred to as covered call writing, this strategy can be implemented using a wide range of index-based ETFs including the PowerShares QQQ Trust, the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) and iShares Russell Midcap ETF (NYSEARCA: IWR). In a sideways to down market, investors can write calls against an ETF, collect the premiums, and then write calls again after expiration if the shares are not called away. The primary risk in this strategy is that option sellers forego any appreciation above the strike price on the underlying shares, having agreed in the contract to sell shares at that level.
Buying Puts on ETFs
Investors seeking to hedge against price declines on their index-based ETFs can buy put options on their positions, which can offset some or all losses on long positions, depending on the number of options purchased. For example, an owner of 1,000 shares of an ETF trading at $80 might buy 10 put options with a strike price of $77.50 priced at $1.00, for a total cost of $1,000. At the expiration of the option, if the price of the ETF drops to $70, the loss on the position is $10,000. The 10 puts, however, have an intrinsic value of $7.50, or $7,500 for the position. Subtracting the $1,000 cost of buying the put options, the net gain is $6,500, which reduces the loss on the combined positions to $3,500. In this example, buying 16 put options with an ending intrinsic value of $6.50 results in a net profit of $10,400, which completely covers the loss on the ETF.
Key Takeaways
- The versatility of ETFs provides investors with a variety of viable hedging options to protect against potential losses and generate income.
- Hedging strategies with ETFs provide the additional advantage of allowing investors to keep their portfolios intact, which may reduce tax consequences and trading costs.
- Despite their value, however, these hedging strategies are best used for short-term and tactical purposes, particularly those employing inverse and leveraged ETFs.
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