There are a number of effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options and volatility indicators.
Modern Portfolio Theory
One of the main tools is the modern portfolio theory (MPT), which uses diversification to create groups of assets that reduce volatility. MPT uses statistical measures to determine an efficient frontier for an expected amount of return for a defined amount of risk. The theory examines the correlation between different assets, as well as the volatility of assets, to create an optimal portfolio. Many financial institutions have used MPT in their risk management practices. The efficient frontier is a curved linear relationship between risk and return. Investors will have different risk tolerances, and MPT can assist in choosing a portfolio for that particular investor.
Options are another powerful tool. Investors seeking to hedge an individual stock with reasonable liquidity can often buy put options to protect against the risk of a downside move. Puts gain value as the price of the underlying security goes down. The main drawback to this approach is the premium amount to purchase the put options. Bought options are subject to time decay and lose value as they move towards expiration. Vertical put spreads can reduce the premium amounts spent, but they limit the amount of protection. This strategy only protects an individual stock, and investors with diversified holdings cannot afford to hedge each individual position.
Investors who want to hedge a larger, diversified portfolio of stocks can use index options. Index options track larger stock market indexes, such as the S&P 500 and Nasdaq. These broad-based indexes cover many sectors and are good measures of the overall economy. Stocks have a tendency to be correlated; they generally move in the same direction, especially during times of higher volatility. Investors can hedge with put options on the indexes to minimize their risk. Bear put spreads are a possible strategy to minimize risk. Although this protection still costs the investor money, index put options provide protection over a larger number of sectors and companies.
Volatility Index Indicator
Investors can also hedge using the volatility index (VIX) indicator. The VIX measures the implied volatility of at the money calls and puts on the S&P 500 index. It is often called the fear gauge, as the VIX rises during periods of increased volatility. Generally, a level below 20 indicates low volatility, while a level of 30 is very volatile. There are exchange-traded funds (ETFs) that track the VIX. Investors can use ETF shares or options to go long on the VIX as a volatility-specific hedge.
Of course, while these tools are certainly powerful, they cannot reduce all risk.