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To Hedge or Not To Hedge

Patrick Ceresna
March 22, 2013
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5 minutes read
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The global stock markets have been kind to investors over the last 3 months as many international markets are up 2-10% in the first quarter alone. But not every investor can share in the celebration. When looking at the average investment portfolio for a Canadian, it has been a mixed picture. This is because the average Canadian investor’s portfolio is likely overweight the “darling” resource names of past. Companies like Potash, Encana, Suncor, Teck Resources and Goldcorp. These investors certainly have made money on a great run higher in Canadian bank and consumer stocks, but when looking at a diversified basket of these stocks, one would be lucky to be flat on the year looking forward to the next round of quarterly dividends.

At the same time, the American markets have reached overbought levels that have many ringing the bell for investors to hedge their portfolio risk with protective puts. If an investor is up 10-15% on their accounts, it becomes an easy decision to spend some profits to buy protection. But is that really the best solution for the prototypical Canadian investor described above?

To me risk is risk. Managing risk should not be a decision made based on if the investor has made sufficient profits to justify it. But does that justify the active buying of protection right across the board in today’s market environment? Probably not. But investors must ultimately build a portfolio that meets their investment objectives. Investors that are focused on dividends and income would commonly focus on building a portfolio that has the highest risk adjusted yield. One strategy not commonly considered is to incorporate covered calls and protective puts into that income portfolio. The most basic version of this is to implement a collar strategy. If you are new to the strategy, watch this short video- http://www.m-x.tv/media/collar-strategy

The intention of this article is not to illustrate the collar, but to explain what impact protective puts and covered calls have on a portfolio. For an investor to comprehend this, one just needs to understand the portfolio’s delta. Delta is a measure of the rate of change in an option relative to the stock price. While the delta on an option dynamically varies, the delta on a stock is always 1. So an investor that owns a basket of stocks has a portfolio that represents full delta exposure. This is where options can play an important role in shifting the portfolio risk. Covered calls (short call) and protective puts (long put) both have a commonality – both strategies have a negative delta. The key difference is that covered calls create income through premium, while protective puts cost money to secure.

The portfolio strategy is simple, if you own a portfolio of stocks – any combination of covered call income that is spent on buying a basket of protective puts notably reduces the risk and volatility of the portfolio. I am not suggesting all the stocks have covered calls, or that there is an equal amount of puts. We are just suggesting that any combination of the two would reduce the volatility of the portfolio while leaving a healthy dividend stream rolling.

Where would an investor be disappointed? Covered calls cut off capital gain upside potential. So the investor must accept that there is a possibility that in a robust bull market, they may not benefit from the full appreciation in the share value.

Where would the investor be satisfied? If the market began a material market correction, the investor may be experiencing proportionately smaller, hedged losses.

Do you want consistency and lower volatility while you collect dividends or do you want the opportunity for full upside market participation? If you are conservative, options can provide the solution.

Patrick Ceresna
Patrick Ceresna http://www.bigpicturetrading.com

Derivatives Market Specialist

Big Picture Trading Inc.

Patrick Ceresna is the founder and Chief Derivative Market Strategist at Big Picture Trading. Patrick is a Chartered Market Technician, Derivative Market Specialist and Canadian Investment Manager by designation. In addition to his roll at Big Picture Trading, Patrick is an instructor on derivatives for the TMX Montreal Exchange, educating investors and investment professionals across Canada about the many valuable uses of options in their investment portfolios. Patrick is also co-host to the MacroVoices weekly podcasts. Patrick specializes in analyzing the global macro market conditions and translating them into actionable investment and trading opportunities. With his specialization in technical analysis, he bridges important macro themes with the attempt to understand when those trends are beginning and understanding where they likely to go. With his expertise in options trading, he seeks to create opportunities that leverage returns, while managing/defining risk and or generating consistent enhanced income. Patrick has designed and teaches Big Picture Trading's Technical, Options and Macro Masters Programs while providing the content for the members in regards to daily live market analytic webinars, alert services and model portfolios.

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