Did you know that you can hedge your portfolio just like a billionaire? In this post I’ll lay out a simple strategy used by large banks, Fortune 500 companies, hedge fund managers, and billionaire investors across the globe.

This is a strategy, that with a little creativity, you can employ in your portfolio as well! It shouldn’t be a secret from which only the rich few can benefit.

[This is a guest post from Patient Wealth. His bio: I live in the Mid Atlantic region with my wife and children.  I am a finance manager for a Fortune 100 Company with over 10 years experience and have an MBA and CPA – but my true passion is investing!]

Before I get into some of the details let me give you the basic idea. What is hedging? Hedging is simply managing the risk of your portfolio through taking a position which makes money when your portfolio decreases in value. This allows an investor to limit losses.

Hedge Funds

You may have heard about hedge funds or hedge fund managers like Bernie Madoff. Or how about George Soros who famously bet against the British Pound? And what about Long-Term Capital Management which went down in flames and almost brought down the global banking system with it?

But hedge funds may or may not employ the strategy that I will be discussing. I want to deal with this first to dispel any misconceptions that may come to mind when talking about hedging.

The term “hedge fund” is loose jargon to refer to an investment fund which is only available to qualified (wealthy) investors as defined by the federal government. They use many many techniques, including but not limited to hedging, in order to execute their strategies.

But these funds can really be doing anything and are not a homogenous group at all. So don’t think about hedge funds when thinking about the strategy of hedging. They are two different things.

So What is a Hedge?

A hedge is simply a way to lessen your risk. Let’s take an example that most of us can identify with. Let’s say there is a trucking company that has contracts to ship goods across the country. The trucking company makes great money and provides good service to their customers. Everyone is happy.

But nothing in the contract allows for an adjustment in the cost of shipping based on the price of diesel. 

The trucking company has a very large risk exposure to increases in the price of diesel fuel. But the risk is one sided. The trucking company doesn’t care if the price of diesel fuel goes down. That will just mean they are more profitable. But if the price of diesel goes up significantly, the company would be not only be less profitable, but could be put out of business completely.

The Business Case for Hedges

Thankfully, the trucking company doesn’t have to sit back and hope that diesel prices stay the same. The company can lock-in a set price for diesel. By hedging the physical risk in diesel fuel the trucking company can ensure a “ceiling” for their diesel costs.

Here’s how it could work. Diesel is at $2.50 per gallon. The company wants to make sure that they don’t pay any more than $2.75 per gallon. That $0.25 per gallon is a big difference for them. A 10% increase in fuel costs would have a huge impact on their business. But the price of oil can easily move by that much. Even within a week depending on what the issue is.

So how does the trucking company limit their cost to $2.75 per gallon? That seems like a perfect world and not something that will be easy to do. Recall that the increase in diesel prices is the risk. However, think about a company like Exxon. They are selling diesel so they are trying to avoid a decrease in fuel prices. This situation has given a rise to a market for contracts to protect businesses from changes in commodity prices.

That market is called a futures exchange.

Futures Contracts to Hedge Risk

Futures contracts are somewhat mysterious and confusing to most investors. But let’s look back at our example and I think it will become clear.

What if the trucking company went to Exxon and said, “hey we’ll sign a contract with you to buy diesel for $2.55 per gallon for the next five years.” Exxon would sign right up for that, if it thought the prices of diesel might be falling, or if it was concerned about hedging diesel price risk.

If the price of diesel went higher than $2.55 the trucking company would be able to continue to buy fuel at the $2.55 price ceiling from Exxon under their futures contract. Exxon and the trucking company simply agreed on the future price of diesel for a specific number of gallons. And that is where futures contracts get their name.

And yes, Exxon would be missing the opportunity to sell diesel fuel at the new higher price. But they were more concerned about the price dropping than on missing out on price increases.

Generally speaking, futures contracts help farmers and commodity producers like mines and oil companies to control the risk of price fluctuations for their products.

Hedging a Stock Portfolio

Now you should have a general understanding of how futures contracts work. But they become even simpler when used in many financial market applications. In the above example, the trucking company is actually using the diesel fuel. But in financial markets these contracts are “financially settled.”

What this means is that the change in price is paid by one party to the other. Let’s continue with our example and this time assume that the futures contract was between two banks speculating in the price of oil. One bank thought the price of oil would go up and another thought it would go down. They agreed on the price of diesel at $2.55 for 10,000 gallons.

If diesel fuel went to $1.55 per gallon, the bank that believed the price would decrease would get $10,000 from the bank that thought the price would go up. It’s as simple as that. When you have a futures contract you are either making or losing money with every change in price of the underlying commodity or financial instrument.

The important feature is that you can make money on either side of the price movement. This opens up an entire new world of investing and risk management.

Application to Stock Market Investments

So far we have talked a lot about diesel fuel. I know that is not very relevant to a stock portfolio but it is helpful to get some background on why the futures market exists. The first time I learned about futures contracts they were explained using soybeans or cattle which didn’t really resound with me.

But the main point is this: you can enter into a position such that you make money during a stock market crash. This is an entire new way of thinking about investing because 99% of investors are only taking positions which are profitable if the stock market moves up. But does that make sense?

I think for the long-term that can make sense. But I also think it is wise to enter into hedge positions during times where the market drops massively.

This could apply to a portfolio of conservative dividend stocks. These stocks may be so conservative that there is very little risk in any one of the stable companies. But the stocks are still exposed to the Systemic Risk of the market as a whole. If there is another stock market crash like 1929, these stocks will still have a breathtaking decline along with the rest of the market.

Conclusion

It follows then that you would want to pick a point at which you were no longer comfortable holding your stocks. That is the point you should set as the entry point for your hedges. My current price for hedging, for example on the Dow Jones Industrial Average, is about 17,989. What that means is if the stock market declines past this point, I will enter (sell short) a significant number of futures contracts which make money on the way down. This is how I reduce the risk of my extreme investing approach. Although extreme investing is not for everyone, I believe using futures as a hedging tool is something that anyone can do.

This would be especially applicable for someone who is concerned that the stock market may decrease significantly but who does not want to sell their long-term investments. By using a hedge, that person could make money on their futures contracts even as their dividend stocks drop dramatically. The net impact to their portfolio would therefore be a very small decrease in value.