Volatility and market corrections are a normal part of any economic cycle, but whenever they happen it can be scary. Seeing the value of your shares drop is never enjoyable.

Being prepared for these events is like taking insurance for your house.

It’s a cost to the investor – you’ll forgo some market performance for some piece of mind.

Of course, having a very low risk profile for investing versus a high-risk growth investment allocation is part of any decision on whether to hedge or not.

Hedging isn’t easy for most investors to do consistently well.

It’s normally done by purchasing securities or an index position that’s inversely correlated with the assets in their portfolio that might be vulnerable.

If prices move in a way that will adversely affect them, the inversely correlated security protects them against losses by moving the other way.

Who uses a hedging strategy?

Hedging strategies are designed to reduce the impact of short-term corrections in asset prices and are commonly used by experienced retail traders, operating under a certain mandate, who have a good knowledge of the financial markets and can predict upcoming changes in the economy.

However, anyone can use hedging strategies, particularly if there’s a large sum of money or an important portfolio to protect, which is why professional traders and institutional investors use them.

There are many different hedging strategies you could use, depending on what you’re looking to trade and which market you’re trading in.

Here are some of the more common ones:

Defensive Portfolio – Diversification is one of the most effective ways to hedge a portfolio over the long term. By holding uncorrelated assets as well as shares in a portfolio, you can reduce overall volatility. Holding cash can also reduce volatility, because the less the portfolio allocates to risky assets, the less it’s likely to lose in the event of a crash. The downside is that cash doesn’t earn much of a return and can lose value due to inflation.

Index Derivatives – Taking a short position in a market index alongside a portfolio of shares gives some investors comfort that when their shares fall, the futures short position will rise. This type of hedge can cover any portion of your portfolio correlation and can change depending on different stages in the cycle.

Put Options – Buying put options gives the investor the right to sell at a certain strike level for a premium paid. Investors could buy put options on individual companies they already own or over the entire index or sector they’re most exposed to and connected with.

Selling Covered Calls – A covered call strategy is done by trading in the underlying stock and an options contract at the same time. If the stock price rises above the strike price, losses on the option position offset gains on the equity position.

Buying Volatility – Buying futures, Contract for Differences (CFDs) or options on a volatility instrument is another way of hedging. When corrections and events occur, the volatility in the market spikes. This volatility can be traded and help offset the movements in your account. Buying protection when volatility is lowest and selling when it spikes is an ideal strategy – but it’s hard to get perfect timing.

Note that derivatives are complex financial instruments best used only by experienced investors.

Steady performers

I’m not recommending that you buy or sell these firms – I’m just showing you two examples of local listed companies that have performed well versus the index during recent market corrections.

Spark New Zealand is a telecommunications company with a large customer base, the type of company that doesn’t offer high growth and is referred to as a value stock.

Focus tends to be on the dividend return. Over the past five years, the NZX50 index is up 65 per cent, and Spark is up 35 per cent.

This year, despite sharp market corrections, Spark is up 8 per cent, excluding dividends, while the NZX50 is down 10 per cent as at April 19.

EBOS Group is Australia’s largest and most diversified healthcare products distributor. Its shares have been trending up.

The NZX50 performance over the last five years is up 65 per cent, but EBOS is up 131 per cent, excluding dividends.

As with Spark, market corrections have not hit the shares too hard, with EBOS down just 1 per cent at April 19, compared to NZX50 being down 10 per cent.

To recap

Risk and uncertainty aren’t pleasant, but they’re a given when it comes to financial markets – and you can seldom avoid them completely.

Portfolio hedging is one way to protect against potential loss and, although it comes at a cost, it can give you peace of mind while helping you take on enough risk to achieve your long-term investment goals.

Disclaimer: CMC Markets is an execution-only service provider. The material (whether or not it states any opinions) is for general information purposes only and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction, or investment strategy is suitable for any specific person. The author does own shares in some of the securities mentioned.