- Shares are trading at elevated multiples as Donald Trump’s election elevates the risks
- Put options are a capital effective, but complex, way of ‘insuring’ a portfolio
- ‘Short’ exchange-traded funds are an off-the-shelf way to hedge ‘long’ exposures
So far, the US market has applauded Donald Trump’s Second Coming, but local investors have been more muted in their adulation.
Still, the local bourse remains at heady levels, despite the explosive geopolitical climate and the risks posed by Trump’s stance on tariffs, China and measures such as tax cuts likely to fuel inflation.
What makes America great does not necessarily make Australia great – and it could be just the opposite.
Is it time to take out insurance ahead of a likely correction? Few householders would forego house or vehicle cover, but not many shareholders give protection a second thought.
The easiest option is to sell out and plonk the proceeds in a 5%, government-guaranteed bank term deposit until the tempest settles. But the chances are, investors will mistime the inevitable recovery.
Asset diversification is part of Portfolio Planning for Dummies 101. Bonds, commodities, currency and real estate are all viewed as being ‘non-correlated’ to shares, but in full-blown market panic that may not be the case.
One capital-light way of protecting a portfolio is to take out a put option by which the investor has the right to sell a specific number of shares (or an index) at a pre-determined price (the strike price).
Investors can select the number of put options needed based on the size of their stock portfolio, thus tailoring the hedge to their specific risk tolerance levels.
Given put options have an expiration date, their value diminishes over time. Longer-dated options are more value and thus costlier.
If the market does not move as anticipated, the option could expire worthless, leading to a loss of the premium paid.
NAB Private Wealth cautions that managing put options can be complex:
“Investors need to be knowledgeable about factors such as implied volatility, interest rates, and the relationship between the underlying stock and the option price.”
In other words: it’s best left to your friendly broker.
A do-it-yourself approach is by way of exchange-traded funds (ETFs) that use short selling to create an inverse outcome to that of a rising market.
“They are not designed to provide the exact opposite of a relevant benchmark return on a given day,” Betashares cautions.
Betashares offers the Australian Equities Bear Hedge Fund (BEAR), which moves inversely to the aims to the S&P/ASX Accumulation 200 Index.
“A 1% fall in the Australian share market on a given day can generally be expected to deliver a 0.9% to 1.1% increase in the value of the fund,” Betashares says.
Of course, the opposite happens if the index rises.
For especially gloomy investors, the Australian Equities Strong Bear Hedge Fund (BBOZ) has the same mechanism, but the instrument is expected to deliver a 2.5% to 2.75% increase in value for every 1% fall in the underlying index.
The cost can be brutal if the market rises: the fund fell almost 30% in value in the 12 months to September 30 2024, while the underlying index gained almost 22%.
Another method is to deploy stop-loss orders, by which a share is sold automatically if its value reduces by a certain value or percentage.
For instance, a share worth $10 might be sold for $9, limiting the loss to 10%.
Offered by some brokers including Commonwealth Securities, a ‘trailing stop’ adjusts the trigger price if the shares increase in value.
A key disadvantage of stop-loss orders is that the loss is made permanent – and if there’s a tsunami of selling, they don’t always work.
All insurance comes at a cost, but few householders would complain of paying a ‘wasted’ premium if their house did not burn down during the coverage period.
This story does not constitute financial product advice. You should consider obtaining independent advice before making any financial decision