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Is it possible to hedge against losses in the stock market?
Not a rewarding insurance for the long term!
Enduring market downturns unscathed, or even “insuring” against falling prices? This undoubtedly sounds very tempting. It is therefore not surprising that there are colleagues who advise this. However, they usually omit a crucial hint, whether consciously or unconsciously: When is it time?
Hedging with Put Options
The functioning is, in principle, quite easy to understand: If you expect falling stock prices but do not want to sell your stock positions, you can hedge parts of your portfolio by buying put options. A put option increases in value when the underlying asset falls. This applies to Eurex products, knockout certificates, or put options. It is also possible to have comprehensive protection for the entire portfolio. At this point, we will refrain from calculating the number of units to be purchased for a given portfolio size and the roles of the strike price and maturity.
The costs of insurance
Security does not come for free, especially not insurance. In this case, it is absolutely expensive. The volatility, i.e., the range of market fluctuations, has a significant influence on the price of a put option – the higher it is, the more expensive. As a rule of thumb, the insurance will cost you between 5 and 10 percent of your portfolio sum annually. In relation to the long-term returns in the stock market, which range between 7 and 9 percent depending on the investment period, this is a considerable sum. The timing problem remains. A permanent hedge would eat up the entire return over the years.
Use market downturns to your advantage
While others groan, the prospect of profiting from falling prices may be tempting. However, those who will earn the most money and outperform average returns are those who continue to invest or even increase their savings contributions in times of crisis – “buying a dollar for 50 cents,” as Warren Buffett has put it. That is also our approach!
The facts:
- By buying put options, a portfolio can be partially or fully protected against price losses in the stock market.
- This insurance costs between 5 and 10 percent of the portfolio sum annually, depending on volatility.
- A permanent “full insurance” would completely eat up the return in most cases.
- It is better to “buy a dollar for 50 cents” in times of crisis.
Our Conclusion:
Insurance always costs money; that’s the nature of things. However, it only makes sense if it provides protection against unforeseen events, at least financially. Corrections are part of the stock market and should be exploited profitably by you. Permanently hedging against corrections will eventually eat up the entire return. A crash usually does not come with a big announcement, so the timing problem remains. As a long-term stock investor, you are better off without such leveraged products.
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