Hedging your equity exposure can save you a significant amount in the case of a sharp turn lower. But it can also have substantial costs and lower your overall returns.
Mark Cuban presents an interesting case on both sides of this argument. In November, Cuban came out and discussed his hedges (http://www.cnbc.com/2016/11/01/mark-cuban-defends-clinton-on-emails-i-dont-think-theres-anything-to-worry-about.html) going into the election. “I’ve put on the biggest hedge I’ve ever put on against all my equities and interest-bearing bonds.”
Now obviously, those hedges are lowering Cubans returns in this incredible bull run to new highs. It isn’t to say that his hedges won’t ultimately work out. He worries that Trump may say or do something that will have a dramatic effect on the stock market, and that is something that only time will tell.
But for Cuban to say he has put on his biggest hedge is saying something. For those in the know, Cuban is known for a huge collar trade that saved him hundreds of millions (a collar involves selling a call to pay for put protection on a stock). He used the collar to lock in his profits on more than $1 billion in Yahoo shares after selling Broadcom. He was able to allow for some upside, but cap his downside in a position where he could not sell the stock (because of the deal). The trade was not perfectly timed, as YHOO soared on the tail of the internet bubble. But then it came crashing down after the bubble burst and Cuban’s trade was pure genius.
Collar trades are great for protection in situations where you must own the underlying. They can be designed in a variety of ways to protect positions and/or profits. Many traders and funds have to hold equities and can’t simply go to cash.
But one of the great things about being a retail trader is that you usually don’t have to hold onto such positions. You can go to cash. Or you can replace your long stock exposure with cheap upside option strategies. A bull call vertical spread has essentially the same profit and loss as a collar against stock, but without the necessity of owning the stock. Because of that, the margin requirements are much lower, allowing for more diversification (as opposed to just levering up the trade).
So Cuban turned out to have a great trade in his collar. So far his recent hedges haven’t been working out for him, but who knows what the future holds. Given this market, it does make sense to buy some cheap downside protection. Or you could replace your stock exposure with cheap calls or even cheaper call spreads. That gives you continued upside exposure so you aren’t fighting the tape, but with a definite downside cap in case anything does go wrong…