How can I hedge stocks

Securing stock portfolios perfectly - that's how it works

The DAX 30 is not making good progress and you can regularly hear warnings about a setback.

I am convinced that the share price will continue to gain, but of course I can never rule out a setback.

That is why I always recommend that you hedge your call options by buying put options.

Options protect your share portfolio perfectly

In this context I am often asked whether and how you can hedge a share deposit.

Secure stock gains

Selling stocks and realizing profits is a theoretical possibility.

But after that you are sitting on (high) cash holdings and you have no attractive investment option for it. Plus, it's hard to get back in at the right time.

2 strategies for hedging stocks

  1. Protect stocks with stop-loss orders

You can use stop-loss orders to hedge stocks.

With this type of order, you sell your shares as soon as they reach or fall below a price that you previously set. You must place stop-loss orders for an unlimited period.

If the stop-loss limit is above your purchase price, the stock gains are adequately secured. I write “passable”. So this is not perfect.

The reason is simple:

If there is a real crash overnight or at the weekend and the prices have fallen massively right at the start of the stock exchange, then your stop-loss order takes effect immediately at the start of the stock market.

The price at which your paper is then sold can be well below your stop-loss limit. Stock gains can turn into losses. Nevertheless, this protection is a reasonable choice.

  1. Hedge stock gains with put options

You can eliminate the disadvantage of stop-loss orders. This is where put options come into play; This makes protection very easy and safe:

You buy put options on the DAX 30. This hedging of stocks is perfect if your portfolio replicates the DAX 30 or contains many stocks from the DAX 30.

However, if you have a lot of small caps or exotic stocks, this hedge may not work ideally. If so, you may have to choose another index as the underlying.

Sample calculation of how to hedge stock gains with put options

Of course, I cannot tell you exactly how many put options you should buy.

That depends on your risk profile and your overall situation. However, an example shows you how you can basically proceed:

First of all, of course, you need the securities account in euros, which is to be secured. I put it here at € 100,000.

In addition, the current status of the DAX 30 is of course important. For this example, I'll set it to a smooth 12,000 points.

A possible formula is then:

Total portfolio: 12,000 points DAX: 5 (5 puts contain 1 contract options)

With a deposit of € 100,000, the invoice looks like this:

100.000 : 12.000 : 5 = 1,66

You therefore need 2 contracts (rounded up) put options on the DAX 30. I recommend December 2018 as the term for the put options (as of April 2017).

The strike price of the put options is around 10% below the DAX level. Here I take put options with the strike price of 11,000 points.

These put options offer you a good level of security if the DAX 30 falls well below 11,000 points by the end of 2018.

The puts cost around € 730. The contract with 5 puts costs € 3,650 accordingly. So 2 contracts cost € 7,300. That is 7.3% of the assumed deposit value.

For this you buy almost 2 years of security - of course: 7.3% is not a small amount, but this purchase offers you perfect security.

Development of the put options

For every 1,000 points that the DAX 30 quotes below 11,000 points, the contract has a value of at least € 5,000, depending on the remaining term.

Examples:

  • DAX 10,000 points = value of the puts € 5,000 per contract
  • DAX 8,000 points = value of the puts € 15,000 per contract
  • DAX 6,000 points = value of the puts € 25,000 per contract

If the DAX 30 halves to 6,000 points, your share portfolio would also halve from € 100,000 to € 50,000.

At the same time, the two put contracts have an added value of € 50,000. Your portfolio is perfectly and 100% covered.

Your advantage when you hedge shares with put options

When stock prices rise, you make profits on your stocks. In the longer term, this is significantly more than you pay for the put protection.

If the DAX 30 falls below 11,000 points, the put options gain roughly as much as the shares lose.

And that also applies if the DAX 30 falls with a crash-like slump overnight or at the weekend, so that you cannot intervene.

Other variants are possible

This is a sample calculation of what a perfect hedge for a share portfolio could look like.

Of course, other safeguards, which are also significantly cheaper, can be displayed. So you can z. B. set the strike price of the put options at € 10,000.

These puts currently (as of April 2017) only cost € 450, i.e. € 2,250 per contract. Then the hedge takes effect optimally if the DAX 30 falls below 10,000 points.

Conclusion

If you are invested in stocks with significant sums, you should not leave your portfolio unhedged with put options.

(Worth mentioning: that is so much that it burdens you noticeably if the deposit value falls by 20%, 30% or 50%.)

Friday is the big day of expiry on the stock exchanges. Tomorrow, for the first time this year, the witches dance on the stock exchanges. What I mean by that and what significance this drama has for you, you can read in this post. > read more


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