Is using ETF index hedging a related strategy?

Exchange-traded funds (ETFs) provide broad market exposure, enabling investors to achieve a wide range of goals in their investment portfolios. This may include providing hedging options for investors who are concerned about economic or market cyclical fluctuations and their impact on investment returns. Here, we discuss four hedging strategies using index-based ETFs.

Key points

  • The versatility of ETFs provides investors with a variety of viable hedging options to prevent potential losses and generate income.
  • ETF hedging strategies provide additional advantages, allowing investors to keep their investment portfolios intact, which may reduce tax consequences and transaction costs.
  • However, despite their value, these hedging strategies are most suitable for short-term and tactical purposes, especially those that use inverse and leveraged ETFs.

Use inverse ETF hedging

Investors who hold index funds or stocks for a long time but are worried about short-term risks can open positions in inverse ETFs. When they track the decline in index value, the inverse ETF will appreciate. For example, Invesco Trust’s QQQ (QQQ) long position,Stocks tracking the Nasdaq 100 index can be hedged by offsetting positions in ProShares Short QQQ (PSQ).With this hedging, Invesco Trust’s QQQ losses were offset by ProShares’ short QQQ gains.

Investors can also use inverse index funds composed of similar holdings to hedge stock portfolios. For example, a stock portfolio constructed to track the S&P 500 index can be hedged with the ProShares Short S&P 500 ETF (SH), which is designed to increase in value by the same percentage as the index declines.

Use leveraged funds to hedge

However, for leveraged inverse funds, inherent volatility leads to lower capital requirements to offset the decline. Through funds that provide triple leverage, such as ProShares UltraPro Short QQQ (SQQQ), The capital required to fully offset changes in the index is about one-third of the long position.

For example, a 3% drop in the US$10,000 position in Invesco Trust’s QQQ would result in a loss of US$300. In a triple leveraged inverse fund, the index’s loss percentage is multiplied by 3 and the gain is 9%. The 9% gain on the $3,300 position was $297, which offset 99% of the loss. Investors should note that due to the daily reset of leverage, the performance of such funds is generally more predictable when used as a short-term trading tool.

Write ETF options

Investors can also choose to use leveraged reverse funds for hedging. Adding leverage to an inverse fund multiplies the percentage change in the tracked index, which makes these ETFs more volatile, but allows smaller capital allocations for hedging positions. For example, the capital required to fully hedge the risk of a long position using an unlevered fund is equal to the amount invested in a long position.

Investors who expect the market to trade sideways for a period of time can sell options relative to their positions to earn income. Known as protected call options, this strategy can be implemented using a wide range of index-based ETFs, including Invesco Trust QQQ, SPDR S&P 500 ETF Trust (SPY), And iShares Russell Midcap ETF (IWR).

In a horizontally declining market, investors can issue call options to the ETF and charge a premium. If the stock is not withdrawn, the call options will be sold again after expiration. The main risk of this strategy is that the option seller waives any appreciation above the exercise price of the underlying stock and has agreed in the contract to sell the stock at that level.

Buy ETF put options

Investors seeking to hedge against the decline in the price of index-based ETFs can purchase put options on their positions, which can offset some or all of the losses in the long position, depending on the number of options purchased.

For example, an owner of 1,000 shares of an ETF with a trading price of US$80 may purchase 10 put options with a strike price of US$77.50 and a price of US$1.00 at a total cost of US$1,000. At the expiration of the option, if the price of the ETF drops to $70, the loss on the position is $10,000. However, the intrinsic value of these 10 puts is $7.50, which is $7,500 for the position. Subtracting the $1,000 cost of purchasing the put option, the net gain is $6,500, which reduces the loss on the combined position to $3,500. In this example, purchasing 16 put options with a final intrinsic value of US$6.50 will generate a net profit of US$10,400, which fully compensates for the loss of the ETF.

Use a currency ETF to hedge the exchange rate

Just like stock market hedging, before ETFs were widely accepted, the only way to hedge non-US investments was to use currency forward contracts, options, or futures. Forward contracts are rarely available to individual investors because they are usually agreements between large entities that trade over the counter.

Individual investors can still try to hedge the exchange rate risk of long non-US investments by purchasing a corresponding amount of short US dollar funds, such as Invesco DB US Dollar Bearish (UDN). On the other hand, investors outside the United States can invest in stocks of funds such as Invesco DB US Dollar Bullish (UUP) to hold long US dollar positions and hedge exchange rate risk portfolios.

Inflation hedge

Inflation hedging using ETFs can hedge against unknown and unpredictable forces. Although inflation has historically fluctuated within a small range, it is easy to fluctuate up and down during normal or abnormal economic cycles.

Many investors are based on the theory that if inflation rises or is expected to rise, commodity prices will also rise, thus using commodities as a form of hedge against inflation. In theory, while inflation is rising, other asset classes such as stocks may not rise, and investors can participate in the growth of commodity investment.

There are hundreds of ETFs that can be used to obtain precious metals, natural resources, and almost any commodity that can be traded on traditional exchanges. Examples include the United States Petroleum Fund (USO) and SPDR Gold Trust (GLD). There are also a wide range of commodity ETFs, such as Invesco DB Commodity Tracking (DBC).

Bottom line

There are many benefits of using ETFs for hedging. The first and most important thing is cost-effectiveness, because ETFs allow investors to establish positions with little or no entry fees (commissions). In addition, since stocks are traded like stocks, the buying and selling process is a simple process for most individual investors. Finally, ETFs cover many markets, including stocks, bonds, and commodities.

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