Hedging is a complex topic, nearly impossible to cover all its nuances in a forum. People hedge for various reasons, and there isn’t a universally “correct” approach —it ultimately depends on your own goals and risk tolerance.
For me, hedging serves two primary purposes:
- To mitigate losses in core positions during a market downturn.
- To provide the confidence to hold core positions instead of selling shares.
Of these, the second goal is more important to me. My investment style focuses on identifying companies with long-term growth potential and holding through market ups and downs. However, human emotions often lead to impulsive decisions (e.g., selling shares like PLTR when it feels overpriced at $50). Hedging works for me as a safeguard against these emotional reactions
One common hedging method is using put options, though there are other strategies available. To reduce the cost of buying puts, sometimes, put spread could be used. An example is the recent QQQ trade with a 25 point put spread with a cost of $4–$5 per share. This translates to a 1% premium to protect against a 25-point drop in QQQ (say, from 540 to 515). For a hypothetical portfolio of $1M in QQQ, the cost of the premium would be $10K. If QQQ continues to drop below 515, the put spread can be rolled lower to a new spread (e.g., 515/490). Also, you dont have to protect the entire porfolio, you could, for instance, only cover 3/4 of the position, which would also reduce the premium cost.
In a rare case you're not familiar with puts or put spreads, you could look up online. ChatGPT offers detailed explanations to help understand these concepts.
The timing of purchasing a hedge is important. Randomly buying put hedges can unnecessarily increase the cost basis of your shares. I think a good understanding of TA, particularly in analyzing market trends, is essential for effectively implementing a hedging strategy. I try to focus the timing of hedge when there are strong signals suggesting the market is overextended and at risk of a correction. For instance, this applied to QQQ at 530–540, PLTR at 70-80, or as Tesla getting close to 500 (I have shared detailed analysis about these price range before). The TA foundation for me in identifyinf market trend is mainly based on Elliott Wave Theory (it’s too complex to dive into details of that here) but there are many others TA tools people use
I’ve been on the wrong side of hedging trades many times. However, even with a 50/50 success rate, hedging can be profitable overall. When wrong, the loss is limited to the premium paid. When correct, the downside protection can be substantial. By coupling hedging with strong technical analysis, you can potentially improve that 50/50 chance to a slight more favorable odds. By "profit," I don’t mean protecting 100% of the portfolio. Instead, the benefit lies in reducing potential drawdowns and avoiding the need to sell shares (which would incur taxes).
As mentioned earlier, this last thing, the confidence to hold core positions and avoid the need to sell shares is the biggest benefit of hedging. When I feel tempted to sell shares, my first thought is, "Why not hedge instead?" If I’m correct, I gain some downside protection. If I’m wrong, I’ve merely paid a small premium while retaining the opportunity to benefit from future gains (e.g., holding PLTR from $50 to $80 instead of selling prematurely at $50). This, by the way, is the entire raitonal behind the mindset of being prepared for a market top but not attempting to picking a top and selling shares. Keep in mind, the possibility for you to being wrong on hedge trade is a: stock goes up which is a good thing overall, or b: stock stays flat which is not so good as you waste premium but, hey, take it as a good overall outcome as that means your main porfolio is untouched. Again, good TA indicators can help in getting better odds at those timing.
I would say if market fluctuations is not a concern for you, and you’re not interested in taking advantge of large trend reversals, then hedging might not be necessary.
