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In today's financial marketplace, volatility is often the rule rather than the exception. For many investors, the overall increase in stock market volatility has generated new interest in defensive investment strategies, otherwise known as hedging.
Used appropriately, hedging techniques can reduce portfolio volatility and help protect against financial loss, making hedging an effective choice even for cautious or conservative investors.
HOW IT WORKS
Two very basic hedging techniques can be effective tools for controlling portfolio risk when used together, particularly when markets are volatile. Selling index call options and buying index put options* are relatively conservative strategies that can be used to help protect the overall value of a stock portfolio by generating income and limiting losses caused by sharp market declines over a short period of time.
- Selling index call options against portfolio holdings allows managers to collect option
premiums in any market environment. In particular, the portfolio receives cash (the "premium") from the purchaser. The purchaser of an index call option has the right to any
appreciation in the value of the index over a fixed price (the "exercise price") on a certain
future date. Since the portfolio will have collected the premium in return for giving up
potential stock appreciation, sales of index call options tend to add to relative return compared
to owning an unhedged stock portfolio – in a flat or fluctuating stock market.
Conversely, in a strong upwardly trending market, the sale of index call options may not
compare favorably to an unhedged stock portfolio, though they will mitigate risk.
- Buying index put options* against portfolio holdings can help decrease the potential for loss if the stock market declines sharply over a short period of time (although the cost of buying put protection reduces total return if the market does not go down).
Through the use of index options, market volatility can be seen as an investment tool in and of itself. The Gateway strategy has employed this approach for more than twenty years. Here's how.
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