Skip to content

Hedging Strategies

Difficulty advanced

Overview

Hedging reduces portfolio risk by taking offsetting positions. The goal is not profit maximization but risk reduction.

Types of Hedges

Options Strategies for Hedging

Strategy Cost Protection Best For
Protective Put High (premium) Full downside Portfolio insurance
Collar Low/Zero Limited downside Cost-conscious hedging
Bear Spread Low Limited downside Mild downside protection
VIX Call Low Tail events Crash protection

Protective Put

Long stock + Long put
Max loss = Stock price - Put strike + Premium
Cost = Put premium

where: Stock price entry price of the underlying · Put strike strike of the protective put · Premium cost of the put option does: caps maximum loss at the put strike while keeping unlimited upside — used for portfolio insurance into known event risk or after a strong run when crystallizing gains; expensive to maintain continuously because of theta decay.

Collar

Long stock + Long put (lower strike) + Short call (higher strike)
Cost = Put premium - Call premium (often zero cost)
Protection = Between put and call strikes

where: Put premium cost of the downside put · Call premium credit from the short upside call does: finances downside protection by selling away upside above the call strike — used by long-only managers to neutralize crash risk at near-zero cash cost, accepting capped upside; particularly common into year-end performance windows.

Cross-Asset Hedging

Commodity Hedging

Airlines hedge fuel, miners hedge metal prices, farmers hedge crop prices.

Dynamic Hedging

Rebalancing Frequency

Frequency Cost Accuracy Best For
Daily High High Active portfolios
Weekly Medium Medium Moderate risk
Monthly Low Low Long-term hedges

Tail Risk Hedging

Strategies

Strategy Cost Payoff Probability of Payoff
OTM Puts Low Large Low
VIX Calls Very Low Very Large Very Low
Put Spreads Medium Limited Medium
Variance Swaps Medium Volatility-based Medium

Budgeting for Tail Risk Hedges

Typical allocation: 1-3% of portfolio annually for tail protection
Think of it as insurance, not investment
Expect to lose money most years

Practical Guidelines

  1. Define the Risk — What exactly are you hedging?
  2. Cost-Benefit — Hedge cost should be less than expected loss
  3. Basis Risk — Hedge instrument may not perfectly track exposure
  4. Rebalance — Hedges decay; rebalance regularly
  5. Don't Over-Hedge — Eliminating all risk eliminates all return
  6. Know When to Remove — Hedges aren't permanent
  7. Test Scenarios — Stress test your hedge before implementation

Next Steps