MONEY 60 - STOCK/MARKET HEDGES

THIS IS MY 60^TH BLOG ON UNDERSTANDING MONEY TOOLS

The stock markets have been hitting highs this past year, in fact they report that the New York Stock Exchange hit highs of this equal only three times since its origination in 1817.

Because of this situation, and an eventual correction to the markets I thought it appropriate to discuss hedging alternatives to help mitigate severe market and stock losses.

We’ll cover both individual stocks and markets, and the pros and cons.  On individual stocks let’s take a look at “stop losses”. I have used these in the past to protect a stock profit position. We’ll work through an example to best understand how it works.

We buy stock in XYZ company at $20/share. The stock moves up nicely to $30/share, and the stock or the market looks questionable as to moving higher. (Mind that if you have significant profit in a stock it is advisable to sell a portion and take some profit out.) Now here is your dilemma. If you sell the stock you will have income tax consequences of either long or short term capital gains taxes both Federal and State, if applicable. (Short term capital gains tax, under 12 months ownership, is your ordinary income tax rate.) To avoid a significant loss in the stock value because of a market correction or negative reports on the company, you might look at placing a “stop loss”. In this case, we might place a stop loss, (similar to a sell order) at $25/share. Looking at the benefit of this is that I still would make $5 per share in profit if the stock drops to $25 or below. There are a couple of things to be aware of, both have happened to me. Before you place a stop loss look at the daily volatility of the stock, the high and low range. With a volatile trading range, if the stock traded below $25/share a sell order would have been executed and you would be out. The negative to this is that perhaps the stock went below $25 for the day and then rebounded again, you would be out.

Another situation can arise where you place a stop loss at $25, however very negative news comes out on the company and there are no buy orders in for the stock until a much lower price is reached. Stocks are sold when there are buyers to buy the shares. Normally, even market makers (investment banking institutions) for a stock will not step in with very negative news and buy the stock “in house”. In this situation you might not have an executed sell until the stock reaches a lower price than your stop loss at $25.

In previous blogs we have discussed other methods of hedging using stock options, which is a different market. The most common methods using options to hedge your stock profit would be to buy “put options” or sell “call options”. On the negative side is: 1) depending on the company you use to trade options most option trades are more expensive than buying stocks, 2) stock options do not necessarily move commensurate to the stock price and 3) stock options expire on certain dates, so a strategy needs to be planned to benefit you on your hedge or money will be wasted.

To hedge your profit position in a mutual fund or market index fund, you should look at “inverse ETF’s. What does that mean?  An ETF is an “exchange traded fund”. Unlike a mutual fund it is valued as a stock based upon supply and demand.  Remember that mutual funds are different. They have an NAV or Net Asset Value based on the value of the stocks in that fund. You can purchase an ETF for a market such as the S&P, a separate index, or commodities. In stock market “lingo” these are referred to as “Spiders”, or SPDR’s. A common one is the S&P 500 ETF with the symbol SPY.  The pros to using an inverse ETF as a hedge is that it will work in concert to your “long” ETF.  On the negative side is if you own the same amount of inverse ETF’s as your long ETF’s you aren’t going to make money as they will balance each other out. Again, your goal here is to protect your profit position, not sell stocks and pay taxes.