When a Hedge Is Not Just a Hedge

You’ve gotta love a diversified portfolio of stocks that work together with the goal of reducing risk and increasing returns. No one stock is more important than another, although you may have your favorites, like those that have outpaced the rest of the market. But maybe a sector seems ripe for a downturn, or perhaps your stock is in a sector that got hit with bad news. And you’re not ready to sell just yet. 

An individual stock can often be more volatile than an entire portfolio. A sector that falls 10% or 20% in a correction can mean twice that for individual stocks. And because you can’t predict a bear market, you ought to be prepared. 

Let’s look at three common but frequently overlooked risk scenarios that could dramatically affect individual stocks. Once you understand these risks and when they might occur, you can create a plan to hedge those holdings.  

Three Risk Scenarios

Stocks can be at risk of a pullback for many reasons. Here are three broad scenarios where your individual stocks may carry risk that might not affect your portfolio as a whole.

Stock risk—For a stock that’s outperforming the overall market, there’s always the risk of the stock coming back down to earth, particularly if the stock market as a whole is falling. For example, if you own any of the five “FAANG” stocks, their high prices may mean they could have further to fall. If a downturn in one stock can spoil your year, your stock risk may be worth hedging. 

Sector risk—Your stock can be affected by news that moves the sector as a whole, such as lower industry demand for products of stocks within the sector. If your stock’s sector has been outperforming the rest of the market, or if your stock is outpacing other stocks in the sector, it could be affected significantly by negative news that hits the sector. Even if the bad news doesn’t apply to your stock, there could be guilt by association. 

Global risk—Stocks can feel the heat when they’re in a sector that’s sensitive to global events. For example, tariffs, central bank activities, and trade wars can affect companies in base metal and banking sectors. If your stock’s sector could be affected by volatility, hedging that stock might be smart.

In each of these scenarios, if you don’t want to sell the stock, it might make sense to simply hedge it. Depending on the volatility of the market and the hedging strategy you choose, you can reduce the risks of holding on to the stock during a downturn, while maintaining some or all of the upside in case the stock should move higher. 

Vol-Based Hedging Strategies

There isn’t necessarily a good, better, or best hedge. Some leave room for greater upside potential, but compromise more downside protection, or vice versa. Among other factors, it’s important to look at a stock’s volatility and use parameters to choose the hedge that matches your outlook for the stock’s risk.

Let’s look at three types of hedges you could consider overlaying on an individual stock position: long put, collar, and covered call. Each has its pros and cons, and each has its own use as a hedge.

LONG PUT

TRADE—BUY PUT

PRO: Preserves most of the upside potential of the long stock and can give you nearly full protection in a crash.

CON: Costs money and increases the breakeven point of the long stock position.

VOL SCENARIO: Low volatility is preferred, as the cost of the long put is likely lower.

If you’re willing to pay for downside protection, while leaving the upside potential unlimited, the long put option may be your style. To place a long put hedge, you simply buy a put with the same strike as the stock price (at-the-money, ATM) or below the stock price (out-of-the-money, OTM). See Figure 1.

Say you own a stock at $175. A $170 put might cost you $5. As long as the stock remains above the strike price of $170 at expiration, then the long put’s going to expire worthless, and you’re out the $5, or $500 per option.* Anything below $170 before the put expires and you’re fully protected, dollar for dollar, even if the stock drops to zero. All you’re out is the $5 you spent on the put.

And what if your stock is falling? Your losses are capped. The max loss for this kind of hedge is the difference between the stock’s price and the put’s strike price, which is $5 ($175 – $170), plus the cost of the put ($5), for a max risk of $10, plus transaction costs.    

COLLAR

TRADE—BUY STOCK + BUY PUT + SELL CALL

PRO: A lower cost hedge because your long put premium is offset by the short call premium.

CON: The upside potential of your long stock is limited to the strike price of your short call. The protection of your stock position generally kicks in only at the strike price of the long put.

VOL SCENARIO: Collar hedges can be placed in any volatility backdrop because at any given time the volatility premium in the short call will typically offset the volatility premium in the long put.

If you think you spot a correction coming, but you can’t stand the idea of paying for a long put hedge, the collar can get you as close to a no-cost hedge as it gets. This hedge combines a long OTM put with a short OTM call wrapped around your stock—the “collar.” (See Figure 2.) The beauty of this strategy is that the call premium you collect helps pay for some or all of the put hedge.

Using the same prices as in earlier examples, the $5 premium collected from the sale of the 180 call offsets the $5 premium of the 170 put. If the stock drops below $170, your loss is limited to $5. Likewise, if the stock moves above $180, your gain is limited to $5.

COVERED CALL

TRADE—BUY STOCK + SELL CALL

PRO: Credit from the short call reduces the breakeven of your stock position.

CON: The upside potential of the long stock is limited to the strike price of the call. Hedging capacity is limited in a selloff.

VOL SCENARIO: Medium volatility is preferred for higher credit premiums to sell the short call. The catch is that higher volatility tends to minimize the protection of the covered call.

This is a one-option strategy—you sell one call for every 100 shares of stock you want to hedge. The short call is typically ATM or OTM. (See Figure 3.)

The covered call doesn’t provide a lot of downside protection, but rather, reduces the cost of your original stock position. For this reason, it’s better suited to late-stage bull markets that could be headed for a correction, or even modest early-stage pullbacks where volatility isn’t exceedingly high.

Say you own a stock that’s trading at $175 and you sell the 180 call for $5 ($500 per option). This reduces your cost basis by $5, and as long as the stock remains below $180 at expiration, the option will likely expire worthless. Keep in mind that in reality, an option that’s $5 OTM can have high vol. 

This leaves room for the stock to profit $5 on the move from $175 to $180. If you add in the $5 premium, that gives you a potential profit of $10. But you could be forced to sell your stock at the strike price if the stock moves above it. And, beyond the $5 reduction in your cost basis, you still have the risk of loss. You can do this strategy multiple times in bull markets, and even when the market is on its way down, so those premiums can add up over time.

The risks posed by individual stocks can be different from the risks that affect your portfolio as a whole. But that doesn’t mean there’s nothing you can do about it. Hedging individual high-flyers, or stocks that can get hit solely because of the sector they’re in, is a strategy that traders could use to reduce the risk these stocks pose, while giving them the chance to profit.