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Hedging with ETFs
Hedging is a strategy for managing risk. It can help limit potential losses or protect gains on a single investment or portion of your portfolio through the purchase of an additional investment. Though there's a price attached, a timely hedge provides insurance that, if you need it, can be well worth the cost.
A timely hedge provides insurance that can be well worth the cost.Equity Options on ETFs
Equity options contracts
on ETFs are among the most
convenient ways to hedge since
options are relatively inexpensive
and highly liquid. If you buy call options,
which makes you an owner or holder, the
options give you the right to purchase the
product underlying the option — such as
shares of an ETF — at a certain price by
a particular date. If you buy put options
you have the right to sell the underlying
product at a set price by a certain date. In
contrast, if you sell a call, you're obligated
to sell your shares if the contract holder
wants to buy. And, if you sell a put, you
must buy if the owner wants to sell.
The amount you pay for the right granted by the option is called the premium, and it fluctuates based on demand for that option and the time remaining until the option expires. But the premium is never as much as the cost of purchasing the underlying product. That's one reason options can be effective strategic tools — though they aren't suitable for every investor.
Hedging With Options
If you own an ETF you think may decline
in value because the index it's linked
to may drop, you might purchase a put
options contract on the ETF. If the share
price falls, the option gives you the right
to sell your shares at a predetermined
price that's better than its market price
any time before the option expires.
If the index does in fact decline, you
can put, or sell, your shares at the option
price and limit your loss, which otherwise
might be much greater. If the index
doesn't decline, you can simply allow the option to
expire and keep
your shares. If they
rebound over the long
term, you'll be in a position
to benefit from the gain.
Using a somewhat more complex approach, you might hedge a portion of your portfolio of individual equities by purchasing a put option on an ETF linked to the benchmark index for that segment of your portfolio. For example, if you owned several technology stocks included in the Nasdaq 100, you might buy a put option on the ETF known as the QQQQ. You might also hedge a concentrated position in a single security, such as your own company's stock, by purchasing a put on an ETF linked to the appropriate benchmark.
As an alternative, you might sell covered calls on an ETF you own, pocketing the cash from the premium to lock in a profit or protect against mild losses. With this approach, though, you do limit your opportunity to benefit from unexpected gains if the value of the ETF increases and the option holder exercises the right to buy your shares.
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