How to Hedge a Stock Portfolio

The short version

Hedging means taking a second position that gains when your main investment loses, so a bad outcome hurts less. It works like insurance: you pay something (a premium, or giving up some upside) to limit the damage if things go wrong. For a stock portfolio, the most common hedges are buying put options, building a collar, holding assets that tend to rise when stocks fall, and simply holding less in stocks.

Every hedge has a cost. If the bad outcome never comes, you have paid for protection you did not use, and over many years those costs add up. For most long-term investors, the cheapest “hedge” is a mix of stocks, bonds and cash that they can hold through a crash without selling. Options-based hedges make more sense for a specific risk over a specific period: a concentrated position, an upcoming event, or money you will need soon.

Why hedge at all

Stock markets fall sharply from time to time. The S&P 500 fell about 57% from its October 2007 peak to its March 2009 low, and about 34% in five weeks in early 2020. Investors who can wait usually recover, but many cannot: they need the money, or they panic and sell near the bottom. A hedge can make a fall survivable, which matters as much as the money it saves.

Hedging is also common when someone has too much in one stock, for example an employee paid in company shares or an executive who cannot sell for a while. Company insiders sometimes report hedging transactions on Form 4, and since 2019 the SEC has required companies to disclose their policies on whether employees and directors may hedge company stock.

Protective puts

A put option gives you the right to sell a stock or index at a set price (the strike) until a set date (expiry). If you own 100 shares at $100 and buy one put with a $90 strike, you cannot lose more than $10 a share plus what you paid for the put, however far the stock falls before expiry.

• Cost: the premium. For a put 10% below the current price, three to six months out, this is often 1% to 4% of the position’s value, more when markets are nervous and volatility is high.
• Good for: protecting a specific position for a specific period, such as around an earnings report or until you can sell.
• Drawback: repeated every quarter, the premiums can cost several percent a year, a large drag on long-run returns.

Our hedge calculator shows the result of a protective put at different prices at expiry.

Collars

A collar is a protective put paid for by selling a call option above the current price. You might buy a $90 put and sell a $115 call on a $100 stock. The call premium offsets some or all of the put’s cost, so the protection can be nearly free. The trade-off is that your gain is capped at $115: if the stock goes to $150, you miss everything above the cap.

Collars are popular with executives and large holders who want to protect a concentrated stake without selling it, which would trigger taxes.

Index hedges and inverse funds

Instead of hedging each stock, you can hedge the market as a whole, by buying puts on an index fund such as SPY or by holding an inverse fund that rises when the index falls.

• Index puts are cheaper per dollar protected than puts on individual stocks, but they only protect against a fall in the market, not a problem specific to one of your companies.
• Inverse and leveraged inverse funds reset their exposure daily. Over periods longer than a day their returns can drift far from the simple inverse of the index, which the SEC and FINRA have warned investors about. They are tools for short-term trading, not long-term hedges.

Diversification and allocation: the hedge most people need

The simplest hedge is owning things that do not all fall together. High-quality government bonds have often risen when stocks fell sharply, as in 2008 and early 2020, though not always: in 2022 stocks and bonds fell together as interest rates rose. Cash never falls in dollar terms. Gold has sometimes held up in crises.

A portfolio of 60% stocks and 40% bonds fell much less than an all-stock portfolio in 2008. It also grew more slowly in the good years. Choosing that mix is choosing how much protection to buy. Our Monte Carlo simulator shows how different mixes change the range of possible outcomes over time.

Position sizing and stop-losses

Holding less of a risky position is a hedge that costs nothing up front. If no single stock is more than 5% of your money, no single collapse can ruin you. A stop-loss order, which sells automatically if the price falls to a set level, limits the loss on one position, but it does not protect against overnight gaps: if a stock closes at $50 and opens at $30 after bad news, a stop at $45 sells near $30. The position size calculator helps you size positions so a stop-out costs only what you planned.

What hedging costs over time

Think of hedging as insurance with a premium. If you buy a put costing 2% of your portfolio four times a year, you pay 8% a year for protection. In a year when the market rises 10%, you keep about 2%. Over a decade with a few crashes, constant hedging has usually left investors with less than holding a sensible stock-and-bond mix and riding out the falls. That is why professional investors hedge selectively: for a defined risk, for a defined period.

When not to hedge

• When your time horizon is long and you will not need the money for many years.
• When you would be hedging out of fear after a fall has already happened, when protection is most expensive.
• When the cost of protection is larger than the loss you are really worried about.
• When you do not fully understand the instrument. Options and inverse funds can lose money in ways that surprise new users.

Examples

A protective put: you own 200 shares of a stock at $50 ($10,000) and buy two put contracts with a $45 strike for $1.50 a share ($300). If the stock falls to $30 by expiry, the shares lose $4,000 but the puts are worth $3,000 ($15 a share × 200), so your total loss is $1,000 plus the $300 premium. If the stock rises to $60, you gain $2,000 minus the $300 premium.

A collar used by an executive: an executive holds $5 million of company stock she cannot sell for a year. She buys puts 15% below the current price and sells calls 20% above it for about the same premium. Her stake can now lose at most about 15% or gain at most about 20% over the year, at almost no cost.

Allocation in 2008: an all-stock S&P 500 portfolio lost about 37% in 2008 including dividends, while intermediate U.S. Treasury bonds gained. A 60/40 mix lost roughly half as much as the stocks alone.

Explain it like I’m 13

Hedging is like wearing a helmet when you ride a bike. It costs a little (it’s hot, you look silly), and on most days you don’t need it. But on the day you fall, you’re very glad you had it. Some people wear a helmet every single ride; others only on the steep hills. The trick is knowing which hills are steep enough to be worth it.

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